by Shelley Seagler
Which stock would you rather own:
– Stock A has a return of 15.8%
– Stock B has a return of -11.5%
I’m assuming this is pretty much a no-brainer, right? In the example above, there’s no way you would choose Stock B over Stock A. So let me ask the question again, but this time, I’ll give you a little more information.
Which stock would you rather own:
– Stock A has a return of 15.8%. In the first month you hold it, the price goes up 12%. In the second month, it drops 6%. In the third month, it goes up 10%.
– Stock B has a return of -11.5%. In the first month you hold it, the price drops 5%. In the second month, it drops 4%. In the third month, it drops 3%.
The second question probably isn’t any harder to answer. Once again, Stock A wins.
One last question – which stock represents the most risk? The answer to this question depends on how you define risk.
If you follow Modern Portfolio Theory, you understand that risk equals volatility, which can be measured using standard deviation. Stock A has a standard deviation of 10, while Stock B has a standard deviation of 1. Therefore, Stock B is by far the less risky of the two. And if this is the only analysis you do when you choose an investment, Stock B must be the better choice. Right?
As we’ve said before, the problem with Modern Portfolio Theory is that it isn’t all that modern. Having a low standard deviation does not mean an investment will have a decent return or even that it will not lose money.
Granted, my Stock A/Stock B example is intentionally simplified. Without the advantage of hindsight, investing is never so black and white. But the point is this, if you want to become a better investor, you must redefine your view of risk.
Consider this, in the 38 years leading up to 2007, there only 98 trading days where the S & P had a gain or loss greater than 3%. Yet in 2008 alone, there were 42 days with a move greater than 3%. In 2011, there were seven days with a 3% swing –from August 1st to October 10th.
Last week, Fortune magazine ran an adaptation of Warren Buffet’s upcoming Berkshire Hathaway shareholder letter, Warren Buffett: Why stocks beat gold and bonds. (My colleague, Jesse Anderson shares his thoughts about this article in Gold Rush.) In it, the Oracle of Omaha offers this statement:
The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period.
For many years, we have argued that the loss of purchasing power is the greatest risk a long-term investor faces. To effectively manage the risk of declining purchasing power, you must be willing to accept a certain level of volatility, because like it or not, high levels of volatility seem to be becoming the new norm.
