Stock Market Volatility – What It Is and How To Profit From It

Stock Market Volatility

Market volatility refers to the unpredictable fluctuations in stock prices that occur on a regular basis in financial markets. Volatility can arise in a couple of ways. If we take a loan and buy a stock, our return would instantly be made more volatile. This post discusses volatility related to pure price fluctuations that aren’t related to leverage, just to be clear!

There are two main approaches to analysing stock market volatility. These are discussed below.

The more volatile a stock, the more risky it is

Why volatility is considered a risk

Volatility is certainly one form of investing risk. It essentially refers to the risk that we don’t receive our expected return each year. Let’s look at the two stocks below.

Stock market volatility graph

Now, both stocks went from $1 to $20 a share over 30 years, averaging a 10.5% annual return rate. However, the certainty of this 10.5% return on a yearly basis differed between the two stocks. On an annual basis, the more volatile stock would generate more variable returns, smoothing out to 10.5% p.a. over the long run. In comparison, the orange stock’s fluctuations are less notable and sizeable. Both are “risky” in the sense that the 10.5% return is not guaranteed each year, however, the risk of the blue stock is higher than the orange.

When is volatilty a risk to our investments?

The question we have to ask ourselves is if we knew at inception that both stocks would be worth $20 in 30 years, would we care which one we owned? The answer is, no, but only if we intend to possess this long-term horizon.

Volatility is only a risk if you have a short-term horizon, needing to buy or sell at particular times in the next few years. Let’s take a 60-year-old retiree as an example. If they owned the blue stock in year 15 planning their retirement on this 10.5% return expectation, they would be shocked to find their investment crash by 33% and 13% in the two following years. In this case, owning a volatile investment is a risk because the unpredictability in the short-term returns is higher than it would’ve been in a less volatile investment.

The more volatile a stock, the more opportunities there are to buy it at a bargain price

If we act as business owners, does volatility even matter at all?

This approach takes a different view of volatility. Let’s take Ben Graham’s lesson of viewing stocks as pieces of businesses, and not as mere pieces of paper that gyrate in price every day. If you inherited your family business, say, a burger restaurant, volatility wouldn’t even be considered. There is no stock market pricing your family burger store. The future stream of cash the business will earn gives it a value, using the discounted cash flow calculation. If we know this value, understand the underlying operational risks of the business, and are planning on holding it for a long period of time, price volatility is completely irrelevant. Let’s assume we expect $200,000 in annual profits from the business. If we are content with a 10% rate of return, this restaurant is worth $2m based on this methodology.

So, upon becoming owners of this business, would we bother to think about the price it would sell for? If it was possible, would we care whether it was valued at $1.9m today and then $2.1m tomorrow, or would we worry about the actual risks that could impact this value? These risks might include the competitive positions of nearby restaurants or the risk that supply costs will go sky high, therefore changing this $200,000 per year profit and thus changing the value of the restaurant over time.

Volatility as an opportunity, not a risk

Now, let’s imagine another identical restaurant was traded on your local stock exchange. The quoted price can gyrate like crazy and be highly volatile or stay flat and thus be less volatile. This should not matter to us as investors. Why? Because we understand the business thoroughly and can make a high-probability estimation for where the business will be in the future. As a result, stock market fluctuations present us with an opportunity, not a risk to mitigate or fear. Let’s look at the chart below.

This shows an example of what might take place in the stock market. The yellow dots were calculated by reversing the discounted cash flow calculation to solve for the rate of return. If we are true business owners, each price of the business offers us a different investment return. When we see it crash under $1.5m, we shouldn’t feel worried or concerned that our investment is less valuable. Instead, we should see that the market is offering us a huge return of 17% p.a. if we buy the business at this bargain price.

Warren Buffett’s thoughts on stock market volatility with an example

Warren Buffett explains his views on this topic in the 2007 Berkshire Hathaway shareholder meeting.

Past volatility does not determine the risk in investing. I mean, actually, take it with farmland. Here in 1980, or in the early 1980s, farms that sold for $2,000 an acre went to $600 an acre. I bought one of them when the banking and farm crash took place. And the beta of farms shot way up. And, according to standard economic theory or market theory, I was buying a much more risky asset at $600 an acre than the same farm was at 2,000 an acre. Now, people, because farmland doesn’t trade often and prices don’t get recorded, you know, they would regard that as nonsense, that my purchase at $600 an acre of the same farm that sold for $2,000 an acre a few years ago was riskier.

As we can see, volatility gets Buffett excited, not fearful. Clearly, he understood the value of the farmland. When prices crashed by 70%, he didn’t care that the investment price was volatile. Instead, he saw an opportunity to yield a huge return on his investment and he seized it without batting an eye.

Conclusion on how to mitigate and exploit volatility

If we are passively investing, one way to reduce volatility would be to diversify

It has been proven that owning more stocks in our portfolios reduces the volatility we experience. However, the issue with this approach is that by adding a 20th or 30th position, we are essentially saying that we would rather put money in our 20th best idea than our first. The best way to achieve diversification would be to be patient. For example, if we just find one good investment idea each year for 10 years, we will end up with a diversified portfolio of 10 stocks. This approach allows us to avoid the pressure of just finding more positions for the sake of diversification and picking poor investments in the process.

We can mitigate the volatility risk by thinking long-term

Let’s jump back to that 60-year-old retiree. To mitigate this volatility risk, they can develop their surroundings so that a market crash would not impact them. If the retiree ensures they have enough cash to handle multiple years of expenses, volatility becomes irrelevant to them. This could mean selling enough of their investments to meet this need. That way, they can still achieve the longer-term return without being pressured into selling out at the worst times. If there is no satisfactory way to do this, then indeed, volatility can be a significant risk, and perhaps less volatile asset classes, such as fixed income, might be better suited.

Another way to stomach volatility is to have a long-term horizon. If one will be investing consistently over the next few decades, we should simply accept that volatility is part of the game. If the destination of our investments will yield a good investment result over time, then short-term volatility is simply irrelevant.

By being a value investor, we can assess the value of a business and exploit the fluctuating prices offered by the market

Now, this sounds good in theory, but in practice, it isn’t so easy to ignore price fluctuations. Let’s turn to one of Warren Buffett’s best quotes below, where he explains Ben Graham’s concept of Mr Market:

Mr Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.

First, we must have the ability and passion to deeply understand the value of our investments. If we possess this, any irrational pricing from the market should not be feared. Instead, if we have spare cash, it can allow us to simply buy and sell depending on how egregious the valuations in the market get compared to our evaluation of the intrinsic value of our investments.

To truly exploit market volatility, we need to isolate ourselves from the noise of the market. If a business we admire and thoroughly understand falls by 50% in stock price, we cannot take this as advice from the market, telling us the business is faulty. Instead, we should treat the market as an irrational, emotional entity that one can take advantage of.

Thanks for reading, I hope you enjoyed it!

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Sources
  1. 2007 Berkshire Hathaway shareholder meeting
  2. Berkshire Hathaway 1987 annual report

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