Real volatility, false risk
Nowadays, tomato prices are volatile, but the stock market is not. At least, that’s what the headlines say. Are they correct? What is the meaning of the word volatility? The word appears to have three related but distinct meanings. Unfortunately, the one that is most commonly used is the wrong one.
Outside the financial markets, volatility means, as a dictionary puts it, undergoing frequent, rapid, and significant change. For example, the weather can be volatile. In the financial markets, technically, it means the amount of variation in a series of traded prices of anything over time. You can get even more technical and talk about the dispersion of returns for a security or an index. High volatility means that the price may change dramatically over a short time period in either direction. Low volatility means that it will not fluctuate dramatically but change at a steadier pace. Note that there is no direction of movement implied in either of these definitions, either the financial or the non-financial ones.
The third definition of volatility is the common and wrong one: Volatility means that the price of something is moving in a bad direction. In the media and social media, volatility means that bad things are happening to the price of something. It’s a ridiculous definition, but it’s the most common one. Technically, when the price of a stock increases sharply, it increases the volatility. However, I doubt whether anyone has ever used the word volatility to describe a sharp increase in a stock price. The word is only used for bad things. Funnily enough, in some contexts, that can mean a price rise. In the current tomato headlines, volatility means a rise in prices!
But let’s talk about genuine volatility. A lot of savers will always choose the lowest possible volatility in the asset class they choose for their savings. The massive preference for fixed-income assets like bank FDs, PPF, and other sovereign deposits that we see are all strong evidence of this. Even within market-linked volatile asset classes, lower volatility is a characteristic many investors chase. Within equity mutual funds, people will choose hybrid funds or only conservative large-cap funds and so on. All this is fine–I’m not criticising this. In fact, I keep a tight check on the volatility of most of my investments.
However, and this is something that few investors appreciate, lower volatility is not free. It has a cost. Perhaps that sounds self-contradictory to you. After all, we have been conditioned to believe that volatility means losses and lower volatility is good. That’s not true. Choosing the right kind of volatility can always boost your returns. To see the truth of that statement, compare equity mutual funds with bank fixed deposits. When you choose lower volatility, you reduce your returns. You are paying the price for stability — volatility in good quality investments means that your investment fluctuates but, on the whole, rises faster.
However, do you actually need the lower volatility? That question is important because volatility is transient. For a quality investment, prices fall but then rise again. The fall in value means that it will soon rise even faster. For investments that have to be held for a long time, paying the price for lower volatility makes little sense. If you can withstand temporary volatility, you should happily and enthusiastically embrace volatility — that’s the road to high returns.
Many years ago, Warren Buffett said, “Charlie and I would much rather earn a lumpy 15 per cent over time than a smooth 12 per cent.” So should you and I. One doesn’t have to be as rich as Buffett and Munger to prefer a lumpy but higher return. One just has to be as sensible and have a long-term view.