Striving to Consistently Outpace The S&P 500 Index
0% Management Fee, Performance Fee Only.
Why Do Investors Fear Volatility?
In the investment industry, volatility is seen as enemy number one. The professionals talk about Beta, Delta, Standard Deviation etc. These terms can be confusing and intimidating to not only the average investor, but sophisticated investors as well. The industry has ingrained into people’s heads that volatility is to be avoided and minimized as much as possible.
If an investor’s proxy for risk is volatility, then it stands to reason why tamping down volatility would be so high in people’s agenda when investing. However, I believe looking at risk through this spectrum is not only incorrect, but it can lead to serious underperformance. Risk should be viewed as the permanent loss of capital and not volatility. In fact, volatility provides the very opportunities that are so critical to long term investment returns. In the following paragraphs, I will explain my thought process.
When investing in a stock, an investor should understand the business dynamics that produce earnings / cash flows for the specific company and understand its estimated value (stock price). Having a firm grasp of these two concepts can lead to wonderful opportunities during volatile times. Lets take a hypothetical example, suppose investor A buys a stock trading at $50.
Investor A believes the fair price of the stock should be $75. Investor A understands the business and nothing has changed in terms of business production, earnings, and cash flows since he bought the stock. Two weeks after his purchase, the stock jumps to $60. This is an increase of 20%. Many investors would sell the stock or at least trim the position to take some profits. If Investor A believes the stock is at least worth $75, why on earth would he sell a piece of business he owns for less than what he thinks it’s worth? Regardless of how quick the movement happened, if a stock price is not trading at fair value or above (all things being equal) Investor A should not sell or trim the stock.
Lets take the flip side of this situation. Two weeks after his purchase, the stock dips from $50 to $45. Perhaps news broke out that there are escalating tensions in the Middle East that could lead to another war or that US-China trade relations are at an all-time low. The plethora of bad global headlines are endless. Again the business dynamics have not changed. An investor might be scared away and sell because he doesn’t want to lose any more money. This would be a devastating decision particularly when it comes to financial markets. The dip has now created a chance to own more of the great business for less money. This is the opposite of risk but instead is an opportunity. If Investor A thought this was a great company at a price of $50, then he should be even more excited about owning more at the lesser price of $45.
A recent article I read perfectly illustrates why it is important to invest in the market, which includes ups and downs (volatility). If an investor had put $10,000 into the market in 1980 and finished in 2020 not missing any days, the returns were truly amazing. However, if an investor had missed the best 5 days of the market during that span or the best 10 days of that span, the results were very different.
$10,000 Invested 1980 to 2020.
1. Return of $10,000 Invested all days: Just shy of $700K.
2. Return of $10,000 Missing 5 best days: About $420K.
3. Return of $10,000 Missing 10 best days: Just above $300K
Just imaging all the volatility during that time span. To the investor who fears volatility, it would have been entirely too much. For better or worse, volatility is a component of investing. A long term investor should embrace volatility as a friend, not an enemy. Once seen as a friend, the opportunities will present themselves. Volatility will remain, particularly given 3 recent dynamics:
1) Trade commission cut to zero by Online Trading Platforms (OTPs), think Robinhood. This has forced larger players like Ameritrade, E-Trade, Charles Schwab, etc. to follow suit.
2) Boredom of the lock down encouraging average investors to trade from lack of sporting bets availability and the “gamification” feel of trading.
3) Influencers on social media suggesting stocks only go up. GameStop stock recently provided an example of this phenomenon.
At least 1 of the 3 mentioned above is here to stay, thus increasing volatility in the markets. A recent study sited that daily active trades were up 75% last year. They made up 20% - 25% of total equity trades, which is an increase from 10% just a decade ago.
Since the inception of Cavallini Capital on July 1, 2017, the market has had one dip of almost 20% and another dip of about 35% through December 2020. That would constitute enormous volatility. Yet Cavallini Capital is up about 104% since inception while the market is up about 65% respectively during the same period through Dec. 2020. Both results clearly illustrate that, though volatility was present, the end result has been excellent.
To view track record, please contact Greg Cavallini at greg@cavallinicapital.com.
The question then becomes, does an investor want to focus on volatility or on returns?
As an investor, one should keep an eye on the ultimate goal: RETURNS.