This is something I think about a lot: is volatility in an investment a true measure of the investment’s riskiness?
At some point this boils down to what you think about efficient market hypothesis. If markets always efficiently price securities, then more volatile stocks are riskier. Volatility is priced-in by academic financial theory. You should pay less for a company if its stock price is more volatile.
Conceptual Investment Risk
Let’s back away from stocks for a second. Suppose you are a real estate investor interested in purchasing properties for your portfolio. There are two houses in the same neighborhood, and they are exactly the same.
Each would bring you $10,000 in annual rental yields. Built in the same year, the two investments should need similar repairs on similar schedules.
There is no immediately discernible difference between the two. Of course, one might be in the path of a future F2 tornado. One might escape unharmed. But the point is that, from sight and available information, the investments appear to be exactly the same.
You hire appraisers to give you a valuation of the properties. Over the next week, 14 different appraisers give you their appraisal for the two properties. You chart these values.
Both homes have a median appraised value of $100,000. Except the first one has a range from $95,000 to $110,000 and the second has a range from $90,000-$100,000.
Which Is the Riskier Investment?
Using financial theory, the home with a wider range in values would be a riskier investment. Ignore that you can secure tenants for both properties and earn the same $10,000 per year in rental revenues. Ignore that the houses are exactly the same and in the same neighborhood.
All things being equal, financial theory says you should discount more aggressively the earnings from the house with a wider range of appraisals than the house with a tighter range.
You tell your real estate agent you will pay $100,000 for the first house and $92,000 for the second. The values differ because you have to price in the volatility risk. He gives you a weird look and asks what you’re talking about. You say the second home had an appraisal of $110,000 on Wednesday and $90,000 on Thursday. It’s just too volatile to justify paying full price.
The second homeowner declines your $92,000 offer, insisting on $100,000 or nothing.
Naturally, you call your property manager. You ask if she thinks you can list both properties for rent; one for $10,000 in annual rents, one for $11,000 in annual rents. You need higher cash flows from the second property to justify a $100,000 investment. Puzzled, she asks if the second home has other features that make it more attractive.
You reply that the home is no different than the second; its value is just more volatile than the first, based on your appraisers’ recommendations.
Is Volatility Risk?
As we navigate these examples, we begin to realize just how ridiculous it is to price the volatility of an investment’s value into what you determine to be its intrinsic value. Why should you pay more or less for an investment property because its value as a property — not the cash flows derived from the rental — is more volatile?
I’d love to have the answer to this, because it doesn’t make a bit of sense to me either.
Going back to stocks, it is correct to say high beta companies are, in general, likely riskier than others. High beta companies probably have more debt or more leverage to the economy at large. But how much volatility is due to reasons that are fundamental to the business’s future?
In short, volatility only matters if investors are rationally making buy or sell decisions based on the future. For example, when John Paulson had to dump shares his hedge fund was holding, the beta of the stocks he dumped went through the roof.
Did Paulson think the firm was less likely to do well in the future? Doubtful — he just needed to return money to investors who wanted to end their financial relationship with his hedge fund. His cashing out had nothing to do with the businesses. Paulson is a huge hedge fund manager though, and his buying and selling impacts very seriously the market prices for stocks when he buys or sells.
Anyone running an analysis on that stock would see higher volatility and determine they should pay less for it, because John Paulson pushed the price of the stock down for a few days. Whether or not new analysts know the stock was rocked by Paulson is a completely different matter. All we see is a higher beta issue than in the past.
So is that right? I don’t think so. I mean, if you’re in an investment for the long-term future earnings potential of a company or piece of real estate, why would volatility matter?