If you tend to catch a cold at the mention of heightened volatility, you are not alone. In fact, in academic theory, volatility is accepted as a proxy for risk. According to renowned investor and writer Howard Marks, this is mostly because volatility is easily quantifiable. You can put an exact figure to it, which allows for quick analysis of the market’s imponderables. Measures like beta and standard deviation are widely used to capture market volatility. So a stock with high beta or a mutual fund with high standard deviation is judged as potentially risky. However, beyond the convenience it affords, volatility as a monitorable entity is shallow, oversimplified and potentially misleading.
Experts insist that volatility should not be confused with risk. Volatility is just noise. It is an indication of how much the price of an asset fluctuates over time. Put simply, it represents the inability of the market to price the security closer to its fair value at that point. “Volatility is a symptom that people have no clue of the underlying value,” asserts British investor Jeremy Grantham. The regular gyrations in stock prices cannot be termed as risk. Volatility, as captured by the market today, in no form indicates the future potential of the investment. It makes little difference to your return.
Volatility, high returns go hand in hand
An experiment showed that the best performing stocks exhibited twice the volatility, but gave five times the returns of the benchmark index.
The real risk is the chance of incurring a permanent loss in your capital. Nehal Mota, Co-founder & CEO, Finnovate, insists, “Volatility is simply fluctuation in stock prices. The actual risk lies in incurring an irreparable loss.” Volatility can only lead to permanent loss if investors choose to materialise losses by selling after a price drop. Anish Teli, Managing Partner, QED Capital Advisors, remarks, “Volatility can manifest into a behavioural risk if you can’t see through the periods of higher volatility and abandon the market at the wrong time.”
The bigger risk is of the underlying business suffering value erosion. Generally, stock prices tend to fluctuate to a much higher degree than the underlying business value. A stock’s price might fluctuate wildly, but if the company’s value remains intact, it is not really a risk. Warren Buffett summed it up clearly, “A wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor, who is totally free to either ignore the market or exploit its folly.”
Volatility is an inevitable part of the market. It is a feature, not a bug, in long-term investing. You simply cannot avoid it. QED Capital Advisors ran an experiment with ‘perfect foresight’ from March 2018 to March 2023 and picked 40 of the best performing stocks from the Nifty 500 universe. The returns of this ‘Perfect Portfolio’ were almost five times that of the Nifty 50, but the volatility was almost two times. One has to be prepared to absorb this volatility to earn that bigger reward.
Experts believe volatility should be harnessed rather than feared. The deviation of stock prices from the fair value represents an opportunity for entering the stocks at a bargain. “For the astute investor, understanding and harnessing volatility, rather than fearing it, can lead to the potential for remarkable gains,” argues Teli. Morgan Housel, author of the bestseller The Psychology of Money, exhorts investors to get comfortable with volatility. “Volatility is the price of admission. The prize inside is superior long-term returns. You have to pay the price to get the returns.”
Treating volatility as a threat gives rise to calamitous mistakes. It makes one stay away from the market at the height of opportunity. Once you acknowledge that volatility and risk are not the same, it will help you become a better investor. Instead of trying to mitigate volatility, you can harness it to your advantage. Investing via SIPs or staggering investments can help make the most of it. Mota says, “Volatility is your friend when investing regularly. It brings you the opportunity to invest at lower levels.”
Make asset allocation and diversification the cornerstones of your investment portfolio to ensure volatility doesn’t trigger your emotional responses. Instead of worrying about volatility, there are other forms of risk that need closer monitoring, namely, concentration risk, liquidity risk, reinvestment risk, etc. As Howard Marks puts it, “There are many kinds of risks. But volatility may be the least relevant of them all.”