One of the real head-scratchers for me is how (and why) anybody would equate volatility with risk. Volatility is NOT the same as risk.
Risk is (or at least should be) defined as the chance of losing some or all of your investment. The path that the price of the stock takes between when you buy it and when you sell it shouldn’t matter, at least from a financial point of view.
I can understand how the path the price of a stock takes matters from a psychological point of view. Let’s say you decide to make an investment in Nike. You purchase some stock and the price goes up 20% in short order.
You feel like a genius. Hell, you ARE a genius! Your only regret is not buying more stock. In fact, now that the stock is up by 20% you decide you probably SHOULD buy more stock. Hell, maybe you should quit your job and become a full-time investor!
“Husband!”* you say. “Bring me my slippers and a martini! I’m too busy investing like a boss to fetch them myself!”
Sell your Nike stock? Why would you do that? It’s a goldmine.
But when the price drops by 20% you start to think that maybe you made a mistake. You start thinking that maybe it’s time to sell the stock and move on.
The psychological impact of the price changes can convince you to make non-optimal choices with your money. But it doesn’t have to be that way.
Buying a stock is surprisingly similar to going to prison
When you buy a stock there are only 2 prices that matter – the price when you buy the stock and the price when you sell it.
And when you go to prison there are only 2 days that matter – the day you go in and the day you get out. (Yes, that’s a clip from “The Wire”. If you haven’t seen it yet, please punch yourself in the face both because you deserve it and so you can use the injury to take some sick time. You’ll need the time off work to binge-watch The Wire. If you’re an HBO subscriber you can watch it for free through HBO on-demand. Otherwise you can buy it from Amazon**. It’s the best TV series ever made. That’s not an opinion – that’s an incontrovertible fact).
Anyway, back to stocks – using Benjamin Graham’s metaphor of Mr. Market, the daily price of your equity investment every day between when you buy the stock and when you sell it are just liquidity bids. The market is giving you the option to buy more shares or sell the ones you have at a price that changes from day-to-day. That’s it.
If somebody knocks on your door tomorrow and offers to buy your house for 1/2 of what it’s worth, would you suddenly decide that owning your house is incredibly risky? Of course not. You’d tell the person to take a hike and continue your day.
And yet, this idea of price volatility equalling risk is endemic in the academic literature. In fact, it’s the basis of most of the statistical measurements of performance that are used to compare stocks, mutual funds, etc.
Alpha and Beta
The goal of most investors is to get the greatest return for a given amount of risk (or, as the academics say, the greatest risk-adjusted return). Alpha is a measurement of risk-adjusted return which uses Beta as the measure of risk.
Beta is the preferred academic measurement of risk, and Beta is just a measure of how volatile one thing is compared to some benchmark. Typically the benchmark used is the S&P 500 index. A beta of 1 means an investment rises and falls in steps with the S&P 500. A beta of 1.1 means the investment is 10% more volatile than the benchmark. And a beta of .5 means the investment is half as volatile as the benchmark.
I can hear my astute readers asking, “But if volatility doesn’t equal risk, then aren’t both Beta and Alpha complete and total bullshit?”
That’s an excellent question. And the answer is yes. Alpha and Beta are complete bullshit because volatility doesn’t equal risk. In fact, in many cases higher volatility equals LESS risk.
Higher volatility equals lower risk??
How so, you ask? Simple.
Let’s say you have a stock that’s just dropped by 10%. Nothing material about the company has changed, but for whatever reason some analyst has just released a report that downgrades the stock from a “strong buy” to a “strongish buy” or “outperform” or whatever is one step below “strong buy”.
It’s the same company that it was last week. It makes the same products, has the same customers, and generates the same profits. Again, nothing material has changed with the company. And yet because of an analyst downgrade it’s now 10% cheaper than it was just 7 days ago. Using traditional measurements of risk (AKA, volatility) this would now be a riskier investment than it would have been if the price had remained unchanged.
That’s right. According to the standard definition, change in the price of a stock = volatility = risk.
Does that make any sense? The stock is cheaper than it was last week. It’s LESS risky to buy it today than it was to buy it at the original price. Yet, because the price changed, it’s now more volatile and thus considered more risky.
It boggles the mind.
What IS risk?
Risk is the chance of permanently losing money. Period.
None of us want to lose money. What are the factors that lead to a permanent loss of money?
- Debt
- Unproven business model
- Debt
- No economic moat
- Debt
- Difficult to predict revenues
- Debt
- New competition
Readers (yes, both of you) might notice a pattern in the above. Debt destroys companies. Why does debt have such an outsized effect on risk? Because debt is a non-negotiable expense. That is, if a company’s sales and profits are dropping there are many ways the company can quickly reduce costs:
- Deduce headcount
- Change product mix (stop selling less profitable products)
- Renegotiate terms with suppliers
- Etc.
But what they can’t do is magically make their debt disappear.
Look at a few examples over the last few years. Seadrill got crushed (stock price down from $46.93 in October, 2013 to $.73 in April, 2017) because they had taken out a lot of debt to purchase extremely expensive offshore oil drilling rigs. Then the energy market fell off a cliff and they had the debt but not the planned income from the rigs. Result: Seadrill is likely facing bankruptcy.
Another example is from President Trump’s past. The bankruptcies of his hotels and casinos were caused almost exclusively by the crushing debt load those companies took on. The properties in Atlantic City were in so much debt that even if they’d performed well it would have been difficult for them to turn a profit.
From the article:
When Trump Hotels went public in 1995, it carried just $494 million in long-term debt. By the end of the next year, under Trump’s direction, its borrowings had ballooned more than three times to a staggering $1.7 billion, or 4.4 times its equity. Conservatively leveraged companies, by comparison, hold half as much debt as equity. By 2002, Trump Hotels’ debt had risen to $2.1 billion and its leverage ratio had expanded to 27, approaching the levels that later sank Lehman Bros. during the Financial Crisis.
Did you catch that? In ONE YEAR the debt went from about $500M to $1.7B. That’s over 3x as much debt. Over time the leverage went from 4.4x to 27x.
I could go on and on with examples of businesses that were crushed by a high debt load.
After all, what happens when high debt meets falling sales? Bankruptcy.
THAT is the correct definition of risk.
How to reduce risk
The easiest way to avoid risk (and I’m talking about the correct definition of risk, which is permanent loss of capital, not volatility) is to avoid debt, both personally and in the companies that we invest in. And this isn’t just me talking – here is Warren Buffett’s advice from the 2016 Berkshire Hathaway Letter to Shareholders:
Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively financed American businesses will almost certainly do well. (emphasis is mine)
Note the key phrase “conservatively financed”.
Further, on page 30 of the 2016 Annual Report Warren lists the acquisition criteria for Berkshire. Criteria number 3 is “Businesses earning good returns on equity while employing little or no debt”.
Debt matters. Companies have been loading up on debt because interest rates have been so low. But interest rates will go up, and when they do, the effect of the debt load on these companies will increase as well.
If you really want to reduce risk, make debt a key criteria in any company that you evaluate.
* – Here at TheMoneyCommando we try to defy gender stereotypes
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Your definition of risk is crying out for an appropriate debt on equity ratio. What do you consider appropriate? Below 1.5 or even less?
“Readers (yes, both of you) might […]” made my day 🙂
For those that don’t know, debt to equity is the ratio of the total outstanding debt to the value of the outstanding stock. The problem is that the value of the stock depends on the stock price, and stock prices are ever-changing.
I prefer other metrics like debt to assets which aren’t based on the stock market’s current mood but instead based on the actual finances of the company.
Obviously the debt to assets ratio will vary from industry to industry, with capital intensive industries (manufacturing, automakers, etc.) having higher ratios than technology and information companies. This makes it hard to come up with a specific debt to assets ratio that applies to all industries, but in general I am very wary of any company above a .5 and I prefer companies that have a .25 or lower ratio. Exceptions abound, of course, and companies like Altria carry large amount of debt but due to their specific business they aren’t particularly risky.
I also look at the interest coverage ratio (earnings divided by interest payments) but this has a weakness in that today’s low interest rates make the numbers look better than they would be in a more “normal” interest rate environment.