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Volatility is Not The Same As Risk

If it looks like risk, feels like risk and acts like risk, it is natural to conclude that it is risk. But in turbulent times, such as now, investors must remind themselves that volatility is not the same as risk.

The stock markets are nothing more than a collection of businesses and risk is highest in individual companies and can be categorised as follows; 

  • The business risk - the risk is what the company is earning today will be lower in five or ten years time. In Ireland, Conduit, Iona, Elan and even Waterford Wedgwood are all names from the recent past but their business models did not stand the test of time or, should I say, changing times.
     
  • The financial risk - the risk that the company has an inappropriate level of debt which increases the danger to equity shareholders. This was the risk that the banks carried and that undid them in the global credit crisis (few saw that danger at the time and include yours truly in that).
     
  • The valuation risk - the risk that you are simply overpaying for the business or its shares which lowers the subsequent returns. Even great companies bought at too high a price can let the investor down. In the late 1990s, Coca Cola's share price briefly peaked at $87 a share. In that same year, Coca Cola earned $1.40 a share. Hence, investors were paying $62 for every $1 of Coca Cola's earnings at that time. Since then, Coca Cola's earning have grown steadily and are expected to reach $4 a share in 2011. Yet, at $64 today, Coca Cola's shares remain 26% below that 1998 peak of $87.

Ben Graham, author of The Intelligent Investor, 1949, described risk as 'the chance of a permanent loss'. If you can't judge these three principle risks in companies then you should avoid owning shares directly and, instead, focus your efforts on investing through funds where diversification significantly reduces the specific risk in owning individual companies.

Volatility has always been part and parcel of stock market investing. Fear, greed and hope can buffet the best laid plans and if you lose control of your emotions due to a lack of understanding of volatility then you may never reap the higher returns normally on offer in risk assets over the medium term despite your good intentions.

There are several ways to neutralise volatility and they differ depending on whether you are a regular investor or a lump-sum investor. The regular investor is one who can add monies to his/her investment programme as they go and they have little to fear from volatility. That can be an ordinary saver or the person with a pension. To drive home the point it is worth examining how a Regular Investor faired during the three worst stock market downturns of the last fifty years, which occurred in 1973-74, 2000-03 and 2007-09. In the 1973-74 bear market the US S&P 500 Index declined by 48.2% from peak to trough but the regular investor, who invested each month starting at the peak of the market in January 1973 was back to break-even by May 1975 just seven months after the market bottomed in late 1974 and just two years and four months from the date on which the investment programme started.

In the 2000-02 bear market, the peak to trough decline was 49.1% in the S&P 500 Index and it took the regular investor, who, again, started investing monthly at the peak in March 2000, two years after the market bottomed and four years six months in total to breakeven.

In the most recent global credit crisis-driven bear market from 2007-09, the decline from start to finish in the S&P 500 Index was a whopping 56.4%. But the regular investor, who started investing at the peak in June 2007, was back to breakeven by September 2010, just eighteen months after the market trough and three years and three months in total. Of course, you had to stay the course and continue to buy at lower prices. That's a strategy for dealing with market volatility and a time-honoured one at that.

The lump-sum investor, who does not have the flexibility to add new monies to his/her investment programme, can employ a different strategy to neutralise volatility. Spreading an investment across several asset classes can help and even better is buying when sufficient value is on offer within equities or property that one can buy and ignore the subsequent volatility.

The severe bout of volatility that has hit markets this past three weeks could be signalling recession ahead. But the business cycle has always been there and always will be. The iShares Euro Stoxx 50 Exchange-traded fund (ticker code EUE and quoted on the London Stock Exchange), which owns a list of fifty top companies in Europe paid out dividends of Stg£0.93 per share in the past twelve months. At the current price of Stg£19.50, this suggests it is offering a dividend yield of 4.75%. European Central Bank interest rates are 1.5% and the risk free German ten-year bond is yielding 2.3%. The value clearly lies within European equities and I suggest the (valuation) risk lies in German bonds.

The volatility we have witnessed in markets in the past few weeks is more akin to the end of a bear market than the beginning of one but only time can tell if that is indeed so. In the meantime, investors must not succumb to the fear of falling prices or they run the danger of converting a temporary loss into a permanent one. 

Rory Gillen
15th August 2011