The Rational Investor #041: Why Volatility is NOT Risk
Happy Saturday to you,
Welcome to the 41st edition of The Rational Investor Newsletter.
Before I jump in, I want to thank you for all the great responses to last week’s note. It was the most responded-to Rational Investor email yet. Keep the responses coming if you feel so inclined!
Today’s quote comes from Howard Marks’s book, The Most Important Thing Illuminated. As I say every time I share a word from Marks, I believe his writing is the best education an investor can get (and for free) via his Oaktree memos.
Today, I’m sharing his thoughts on why he believes that volatility is NOT risk and what he believes risk to be. I’ll share a few thoughts on this matter following today’s quote.
Onto the main event…
Here’s Howard Marks on Why Volatility is Not Risk:
“According to the academicians who developed capital market theory, risk equals volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition of risk.
It’s my view that—knowingly or unknowingly—academicians settled on volatility as the proxy for risk as a matter of convenience. They needed a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risks do not. The problem with all of this, however, is that I just don’t think volatility is the risk most investors care about.
There are many kinds or risk…But volatility may be the least relevant of them all. Theory says investors demand more return from investments that are more volatile. But for the market to set the prices for investments such that more volatile investments will appear likely to produce higher returns, there have to be people demanding that relationship, and I haven’t met them yet.
I’ve never heard anyone at Oaktree—or anywhere else, for that matter—say ‘I won’t buy it, because its price might show big fluctuations.’ or ‘I won’t buy it, because it might have a down quarter.’ Thus, it’s hard for me to believe volatility is the risk investors factor in when setting prices and prospective returns.
Rather than volatility, I think people decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return. To me, ‘I need more upside potential because I’m afraid I could lose money’ makes an awful lot more sense than ‘I need more upside potential because I’m afraid the price may fluctuate.’ No, I’m sure ‘risk’ is—first and foremost—the likelihood of losing money.
The possibility of permanent loss is the risk I worry about, Oaktree worries about and every practical investor I know worries about.”
While I wholeheartedly agree that true investing risk is just as Marks says—the permanent loss of capital—I feel compelled to share a key point that I believe is regularly glossed over.
That is, principal risk is a myth for owners of a broadly diversified equity portfolio.
Think about this for a moment…With the market closing at an all-time high yesterday, this means that you could have bought the index on literally any day over the past 100 years, and you’d be at an all-time high right now—as long as you never sold.
That last part is the critical part.
This means that ALL investing risk must, by default, be behavioral in nature because the only thing required to be at all-time highs today was to have bought the market and then never sold.
In other words, historically speaking, any (and every) alternative decision—other than simply leaving their portfolio alone to compound—would have introduced the possibility of a permanent loss of capital.
If you pause to appreciate the simplicity of this idea, you will find great freedom as you consider your investing future.
Thanks for reading. I’ll be back next week with more timeless wisdom from great investors.
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