When it comes to finance and money, we tend to complicate things. In many ways it is quite understandable. Money is a very emotional subject for almost everyone and we spend all our lives in pursuit of, tending to, and judiciously spending our wealth.
The way we have traditionally thought about risk in investing is counter-productive.
Let me explain.
The Traditional Definition of Risk
A very simple yardstick to measure risk is: do your investments allow you to sleep well at night?
So we end up with situations where we worry a lot when one of the investments we own goes down. We may even get rid of an investment to ease the pain of capital losses.
The volatility and bearish market conditions we have had in the past few months have caused many investors to exit the market, either by selling everything and going into cash, or reallocating to bonds and other safer instruments.
Most investors think of themselves as smart, objective, calm and deliberate and able to make rational decisions in times of market stress. The reality is exactly the opposite. When the markets decline, the investors with emotional fortitude continue to stay in the market and make the right decisions, but only up to a point. As the declines deepen, the investors who have kept the faith start to waver, and eventually there comes a time when they give in and start selling. Sure, this threshold is different for everyone and some great investors are better able to tune off the market madness than most others.
But everyone has a pain threshold.
I am painting a grim picture, but the reality is not much different. The reason this happens is that the topic of money and investments trigger the “fight or flight” response in human brain. When this happens, the person is left with only one choice: to act. Rational thought is superseded by the necessity to act. Do something, do anything, just get out of danger.
The computers are no different.
For decades, academics and the Wall Street has defined Risk in terms of volatility. A stock that is highly volatile compared to the market is termed as “risky”. This way, the academic definition of risk mirrors primeval human survivalist definition of risk.
Depending on the trading algorithms, the automated trading software will either try to avoid risk (by leaving a volatile situation), or try to hedge it out (by acquiring another asset that moves in either opposite direction, or is uncorrelated with the risky asset).
When we have a bear market decline, many of these models breakdown and the carefully constructed hedges are no longer functional. Therefore, a wave of selling results to recover that balance.
So What is Wrong With the Traditional Definition of Risk?
In short, it makes you sell when the prices are low and buy when the prices are high.
When the markets are falling, we should be looking to buy suddenly cheaper assets. The volatility here makes us instead try to sell what we do own. When we have a roaring bull market is when we should be afraid. Very few investors are willing to sell stocks when they see it go up every day.
When assets are priced low and at a discount to their intrinsic value, is when they are less risky. When the assets are priced higher than their intrinsic value, is when they are most risky.
Redefining Risk by Separating it from Volatility
It is quite easy to get caught up in situations as they are happening and lose the objectiveness. However, a few key principles can remind us what really matters so we can take a calm breath, step away from that Sell button, and reassess.
- Risk is NOT the same as Volatility. In fact, volatility of a stock is in most cases a function of how liquid the stock is. If there are not many shares available to trade (a small company stock, for example), the stock will be volatile.
- The academic theories do not prescribe how the market should function. They are an attempt to understand how the market functions. These theories change over time. We are better advised to pay attention to the basic principles of investing and understand that the market is made up of 1000s of thinking feeling humans just like you and me.
- The only risk that matters for an investor is the risk of capital loss over the holding period of an investment. Therefore, when you research a stock and decide that it makes sense to hold this stock for 5 years (example), because you can see the business grow to a level in the next 5 years to provide you with an attractive return, what happens tomorrow in the market is irrelevant as long as the business is not impacted.
- We tend to think of market as a rational pricing system. It is not in the short term. There is a saying, “In the short term the market is a voting machine. In the long term the market is a weighing machine”. Once you realize that the price variations on a daily basis are a sum total of short term emotions of 1000s of investors and traders that particular day, you will also realize that there is no reason to trust the emotions of these other investors more than you trust your own rational judgment.
Follow the advice on how smart investors should handle the volatility in the stock market. If it is still tough to ride out the volatility, some drastic action is required. Turn the TV off, step away from the computer, and go for a walk. A nice walk almost always gives us a better perspective on whatever we are panicking about.
Shailesh Kumar runs the popular value investing service at ValueStockGuide.com, where he advises clients with long term value investments. Subscribe to his blog here.