“Risk adjusted returns”. That’s one of the more common phrases you will see on fund manager websites. It is, after all, what we are all trying to do: maximise returns and minimise risk.
The return part of that equation is a straight forward number. But how do we measure risk? And who am I minimising risk for? They are not easy questions to answer. Certainly not as easy as the industry would have you believe.
As the sole measure of risk, share price volatility has been a bugbear of mine since I studied economics at university. It simply made no sense to me that a company whose share price was volatile was necessarily riskier than one with a stable share price.
Volatility is not risk for everyone
One, your time horizon is crucial. If you need to sell your shares next week, then stock price variability is a significant risk for you. If you have the capacity to hold an investment for 5 or 10 years, what happens next week doesn’t matter.
Second, volatility is itself a variable. A stock that has historically shown very little volatility can become highly volatile, and vice versa. Look no further than March’s meltdown, where shares in airports went from trading like infrastructure safe havens to highly volatile tourism stocks.
Most importantly, though, for an investor with a long time horizon, volatility can be more friend than foe.
Volatility is risk for someone who needs to sell. For someone who wants to buy, it can be an appealing feature of an investment.
Low prices equal lower risk
We want to buy shares at highly attractive prices. Almost by definition, the more a share price bounces around, the more chance that, at some point in time, it trades well below its fair value.
Further, the smaller the gap between your purchase price and fair value, the higher the risk that fair value is less than your purchase price over the long term.
When used to invest at low purchase prices, higher volatility can actually reduce investment risk.
Market volatility can be stomach churning. It’s hard to enjoy your breakfast when reading about the billions of dollars “lost” on global sharemarkets. But, if you’re a Forager client, you should welcome it. With volatility come the genuine opportunities for risk-adjusted returns.