Author: Ben Tewey
Published: 4/12/21
Introduction and Credit
My ideas on investing are a conglomeration of Warren Buffett’s, Ben Graham’s, Bill Ackman’s, and various “FinTwit” members. I want to highlight one of those members of Financial Twitter in this article: 10K Diver. He recently masterfully articulated the difference between volatility and risk. A topic I have been meaning to write about for some time now. His analogy is incredibly easy to understand and I wholly recommended you read his thread. I had meant to write this article at around the time of my Visa analysis, but it slipped my mind. Therefore if I had not read his thread I would have completely forgotten to write this article.
Explanation of Volatility
In order to explain volatility in the most straightforward way, I will paraphrase/abbreviate what 10K Diver went into on his Twitter (again check it out– all credit to him).
First, there’s Biz and his little golden retriever Spock. He is a good boy. Every morning this tandem goes for a walk in the park for about an hour and then they head on home. Biz walks at basically a steady pace of 3.5 miles per hour, but Spock (being the good boy he is) does not. He will sometimes run ahead and strain his leash to see another dog or get caught up and stay behind to sniff a fire hydrant.
Over short durations, the two have little to no correlation because Biz at his steady pace always advances 47m in any 30 second interval. Spock on the other hand is far less predictable. In some thirty second intervals he will advance 200m, while in others he drops back 100. However, over longer durations, say 5 minutes, Spock’s movements are much more predictable.
There are other dogs, too, at the park (I assure you they are all good boys and girls, too). Some are younger, more energetic or simply on a longer leash and they are even more unpredictable than Spock. Still, other dogs are slower, maybe older or have shorter leash and therefore they are much more predictable than Spock. Dog owners too vary- some slow, some fast.
Now imagine we have a whole bunch of (dog, owner) pairs. Say, I don’t know any random number- 500 of them. Some dogs are very calm. Others are very energetic. Some dogs are on short leashes. Others are on long leashes. Some dog owners are brisk walkers. Others have had long days. If we were to average all 500 of these to a single pace and assign the average the number 1. This would allow us to have a center point to reference the other dogs/owners around. The more unpredictable the movement the higher the “beta.” This would measure how unpredictable Spock, or any other dog’s/owners’ movement is.
However, over long durations beta is almost meaningless. This is because, in the long run, dogs go where their owners go. Let’s say we give each dog a treat if they finish their three mile walk in 1 hour. If “risk” is the probability of failure in the long term, then beta is not particularly relevant in assessing risk. You may have a particularly “volatile” dog that will finish their walk incredibly fast and does not run the risk of being late. On the other hand, there may be a 15 year old German Shepherd that has very low “volatility” and plods along at a more or less constant pace of 2 miles per hour. His “risk” is inherently higher because he will not reach the finish line in time for the treat. (I still think we should give him one, but that’s just me personally.)
Volatility vs. Risk
Currently, I am working my way through the Berkshire Hathaway Annual Meeting Recordings (the 2020 meeting is linked, but the channel has every meeting back until 1995) and despite only being on the 2003 meeting, I have heard Mr. Buffett and Mr. Munger describe in the simplest terms that, “Volatility does not measure risk.” So how can this be? How can academicians- incredibly intelligent and capable people who have dedicated their entire lives to studying finance- rely on volatility and the use of “beta” to determine risk? According to Buffett, it’s simple: they want to measure risk, but they don’t know how to do it. Therefore, they rely on the much nicer, clearer (and frankly, easier) calculation of beta. Risk, according to Buffett, should be thought of in terms of business risk only because, of course, stocks are a part of businesses and not lines that wiggle up and down on a screen.
One example of the shortcomings of measuring risk through volatility is exemplified in the Washington Post Company in 1973. Buffett opened his position in The Post after a 50% decline in market cap from 180 million down to 80 million, due to the rapidity of this decline the beta of the stock increased. If it were true that beta equaled risk this would mean the Washington Post was more risky at 80 million than it was at 180 million. That’s hard for me to wrap my head around.
In summation, the intelligent investor should welcome volatility in the market because it presents intriguing buying and selling opportunities. Wild fluctuations in the market allow businesses to be sold at intriguingly low valuations and sold at sufficiently high prices. Peter Lynch said it well in this speech “$14 to $22 is terrific, $6 to $22 is exceptional. So you take advantage of these declines” Lastly, if you can’t stomach a 25% decline in stocks every 3-4 years then you shouldn’t own stocks.
Conclusion
In short, risk should be pondered over by the intelligent investor without a doubt. However, it should be thought about in the context of business risk, or the probability for future cash flows to be negatively impacted. Volatility, on the other hand, measures stock price volatility and, as mentioned numerous times in past articles, a true investor should not fret over the day to day, or even month to month, gyrations of the stock market.
Bibliography
10K Diver’s Twitter Thread on Volatility vs. Risk
Mr. Buffett and Mr. Munger on Volatility vs Risk at the 1997 Berkshire Meeting
Disclaimer
I am not a financial advisor. These articles are for educational purposes only. Investing of any kind involves risk. Your investments are solely your responsibility and we do not provide personalized investment advice. It is crucial that you conduct your own research. I am merely sharing my opinion with no guarantee of gains or losses on investments. Please consult your financial or tax professional prior to making an investment.