Volatility Is Not Risk

Tyler Durden's picture

From John Goltermann of Overmeyer Asset Management

Volatility Risk

John Bogle, the founder and CEO of Vanguard Funds, appeared on CNBC a few weeks ago to be queried on the Facebook IPO debacle. In his interview, he provided a great nugget of wisdom with the following statement: “Betting on value is an intelligent way to own property as compared to trading in stocks.” During the interview, he also commented that there are way too many people speculating on price and very few who focus on value. As usual, John’s clearthinking conveys the right way to approach investing. We agree that value, or lack of value, is the true source of reward and risk.

Dramatic price moves and the substantial volatility of recent years is why many people struggle with the current market. Volatility understandably creates anxiety, especially with the cost of living rising as it is. Many would rather take a zero return in cash and bank deposits than be subjected to the emotional adversity of a negative month. This is a situation that will likely remain the case for some time, but this is also why values abound!

Let’s face it: downward volatility is really the only type that unnerves investors. Upward volatility is welcome all day long. While I ultimately want to focus on framing the reality of market volatility, it may help to provide some background on one of the major sources of its occurrence.

Joseph Schumpeter, an economist and political scientist, wrote that an economic “recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustments, new maladjustment of its own…” These words cogently remind us that while government stimulus – through low rates or other measures – can help in the near term, ultimately it does not actually solve problems. It merely moves them around and defers them. It is important for investors to realize that many still look to the U.S. government to address the festering problems of high unemployment and declining competitiveness (the true legacies of excessive debt expansion), but they fail to realize that it was the government and the central bank that were largely responsible for those problems in the first place.

By providing stimulus after stimulus during periods when the system was trying to cleanse itself, needed adjustments were deferred to later periods and possibly even handed it off to subsequent generations. Today, the continued clamor for government solutions empowers Congress, the President and the Fed to try to tweak, minister, guide, cajole and jawbone the economy, making for a highly charged political backdrop and a very unpredictable, volatile investment environment.

Some may point to Wall Street as the source of today’s problems, but the truth is that banks simply acted on incentives that were put in place by Congress (through Fannie Mae and Freddie Mac), by the Federal Reserve (through monetary policy), by the Glass- Steagall Act of 1933 (which created the FDIC) and by the repeal of the provisions of the Banking Act of 1933 that limited affiliations between commercial banking and securities firms.

In the last 25 years, the government has done much to encourage private sector borrowing and relax regulation, and in the process has created a speculative economy with high debt levels.

Increasing debt levels was a politically convenient way to mask declining real wages and a way for people to maintain their living standards. While the government will likely continue to pick winners (speculators) and losers (savers), it can do very little to fix current imbalances or create a competitive economy.

For jobs, it can only hire people directly or encourage industries to expand through subsidies; but without offsetting tax increases, this furthers a rapidly deteriorating fiscal condition, which in turn impairs confidence. In a similar vein, trying to stabilize housing and improve wealth creation by holding interest rates too low simply encourages speculation to the peril of those who don’t speculate well and to the benefit of those who do. Actions have reactions, and not all of them are constructive.

I could write ad nauseam about what’s happening in investment markets, but what should ultimately matter to an investor is “value” – that is, what is received in return for capital invested. Price volatility, which is independent of value, too often is regarded  as something to be avoided. In fact, the best assets often have high levels of price volatility. Downward volatility itself causes a momentum effect of continued selling, which brings prices that make for attractive entry points. As the chart below indicates, high volatility (as indicated by the VIX index) occurs often at the moment of the lowest price (greatest value), and is coincident with the highest fear, lowest lagging returns and the best subsequent returns. While high volatility doesn’t predict future average returns, it can be a useful guide for productive investing.

This concept also applies to individual investments. Assuming the fundamentals of the investment haven’t permanently changed for the worse, great investments can be subject to significant downside volatility for no apparent reason and can stay below their value for long periods of time. This is what makes patience and focus invaluable attributes of successful investors.

Adverse markets come and go, as do market liquidity and confidence, but it is a universal truth that long-term investments (not speculations) are better made in adverse markets than in euphoric markets because good values are more pervasive. The question is not when and by how much something might go up, but what the risk is and how much you get paid to take it! And everything has risk of some kind, including cash and CDs; one just needs to pick the risks that are best to take.

What makes for a good investment is price. Price is everything. You need to receive value in excess of the price paid. An investment’s value is the amount of real cash its underlying assets can reasonably be expected to deliver to its shareholders in the future, discounted for its risk – period. The investment’s price will either be higher than its value (an uncompensated risk), the same as (neutral) or lower than its value (a compensated risk). But since value is an imprecise measurement, the best one can do is to build in a margin of safety by buying investments that are at deep discounts to a reasonable estimated value.

Too many investors let an investment’s short-term price movements, or perceptions of short-term price movements drive their decisions. But since short-term price moves are unknowable, irrelevant and independent of investment merits, this is not worthy of any time spent analyzing.

If short-term price moves were knowable, then a cadre of top-performing chartists and market technicians would have far greater net worths than Warren Buffett, Charlie Munger and the Saudi Royal Family. They would need only apply leverage to their process and repeat it a few times in order to accrue hundreds of billions of dollars. Question: How many market technicians occupy the Forbes 400? Answer: Zero. Why? Because successfully guessing future price moves based on charts, MACD indicators or tea leaves is not a repeatable process. Investors who do this generally have poor outcomes because they are pursuing answers to the wrong question.

The right question is: where is the value?

The Facebook IPO was a perfect demonstration of this. Many people bent over backward to procure shares in the offering because of the strong consensus that it was a one-way bet that would rise in price post-release. A month of television airtime was spent ahead of the opening trade talking about the IPO. The focus on price, without regard to value, cost many individuals and institutions significant amounts of capital.

This leads to the definition of risk. Unfortunately for many, the investment industry often operates on the premise that price volatility equals risk and is something to be minimized or avoided. This reflects faulty logic because price volatility is independent of risk. Seth Klarman of the Baupost Group properly defines risk as 1) the size of a potential loss and 2) the probability of its  occurrence. He refers to losses of a permanent nature (not volatility-related), and I would add that they need to be measured in real (i.e, after inflation) terms. For example, cash has lost significant value through time as it is continually debased by the Fed.

Although cash experiences no price volatility, it is risky.

To illustrate what risk really is, consider the following chart:

Kodak cameras and film enjoyed product ubiquity at one time, but this didn’t prevent a 100% loss of capital for buy-and-hold investors who became complacent about the company’s dividend, management and/or the brand name. Ubiquity does not provide a margin of safety and great companies can see abrupt and permanent losses in their primary assets’ value. And if someone tells you that that can’t happen to certain companies, and gives you a host of reasons why not, put one hand over your wallet!

No level of financial analysis performed when business is good can tell you what will happen when a company’s assets begin to lose relevance or deplete. Kodak, RIMM, Nokia and a multitude of others, serve as cautionary tales as to what can happen to a business and its stock price when its intellectual property loses its usefulness. This is risk.

To avoid such risk, attention needs to be paid to price, and conservative assumptions need to be made to estimate value. This will go a long way towards stacking the odds in your favor of having successful outcomes over time, and can help relieve the anxiety that comes with gutwrenching market gyrations and gloomy projections of the future.

For today’s challenging environment, mental preparedness and a focus on what truly matters is paramount. While these are indeed tremendously tricky times to invest due to the macroeconomic and political factors that receive so much attention, these are also great times for those who have both capital and time and who focus on value. For those who speculate on price, these are perilous times because of the pervasive view that volatility is risk and the huge amounts of capital that is traded accordingly. Great assets bought well give comfort that no matter what prices do, there is something tangible and real that backstops the price and reduces risk.

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urbanelf's picture

I prefer metal preparedness over mental preparedness.

TheGardener's picture

Good first, sarc tag out of the way , jingo is the way to go.


You prefer nothing.

SemperFord's picture

judging from the previous spikes, is the VIX about to soar again?

indianajohns04's picture

I hope so bought 2,000 UVXY @ 14.88! I understand that it is pure gambling but it'll be a good hedge against my IRA.

sablya's picture

Wow, did you buy after hours?  That's an amazing buy.  I have 2000 UVXY also but I'm closer to 16.  I don't mind though.  I invest in volatility....lol, volatility **is** value. :)

ndotken's picture

Buying UVXY or VXX or any other inverse ETF is not gambling if properly used as a hedge on your portfolio.  That's what it was designed to be used for.  But in case you didn't know, those types of ETF's and ETN's were never intended to be long investments.  In fact, their prospectus even states that those investments WILL, given a sufficiently long holding period, result in a 100% loss of captial.  I can't think of any riskier investment than one with a guaranteed 100% loss.  Beware!!!

kalasend's picture

Yeah, I think so too.

Problem is, I've seen similar comments on many boards these days. I guess we are all going to get rich?

Clint Liquor's picture

The Markets have become so corrupt and manipulated none of this is applicable anymore. Price has become an illusion.

Fear not for HFT is providing all the nanoseconds of liquity the market needs.

Thomas's picture

The Fed has rendered our hard earned and saved capital worthless by flooding the market with free capital. What a bunch of dicks. When does the violence begin.

ACP's picture

Hey, don't knock tea leaves!

El Oregonian's picture

Lawyers for Ron Paul have taken over Paul's campaign and will have him nominated as the Presidential candidate and have Mitt Romney stripped of his delegates! Great interview and a MUST LISTEN.  Finally, some really great news on dismantling this Tyranny! Long Live Liberty!!


fuu's picture

The whole thing is pretty wtf, or a Facebook commercial.

El Oregonian's picture

No, its for real. The mafioso's that are nothing more than two crime syndicates will hopefully be finally exposed.

Mordan I's picture

I am. So just suck it up. Get on the that horse. I told you .... 

TheGardener's picture

Prices makes for civilized exchanges of goods.  Dramatic changes in valuations that can

not be priced into human behavior make for big upheavals.

Pairadimes's picture

And in other news, NASA reports that the sun is still hot.

Mordan I's picture

It has been a while but I am here. Change no and yes. Maybe I should give myself a break? 


TrillionDollarBoner's picture

Yes, I think you should give everyone a break and stop clogging up the airwaves with impenetrable pseudo-poetic banalities. 

Standard Deviant's picture

While the general point might be fine, facts are wrong.   At a minimum both Paul Tudor Jones and John Henry made use of technical analysis when amassing their fortunes.    I don't know many of the names on the list, maybe others did as well.

junkyardjack's picture

Exactly.  You can certainly create more Alpha so to speak if you can pick great names to buy but if you are ignoring price you are going to end up in trouble.  You also need to know when you cut your loses which is much harder if you believe you know the real "value" of the company that you are holding.  Stops are the most important part of trading


Diogenes's picture

You can add Jack Dreyfus of Dreyfus Funds to the list. He said that his "secret weapon" in the fifties was a weekly average posted daily, in other words a moving average.

orangegeek's picture

Nothing wrong with the MACD (or other oscillators) when used in conjunction with other tools.


What is astonishing is watching the USD (down again today) continue to incrementally decline.   Half the US Index is the Euro.



Zero Govt's picture

this article is a pitch for value investing 

i'm not aware it works


junkyardjack's picture

Even good value investing needs chart reading to know when to enter a trade

RobotTrader's picture

How many "Market Technicians" and "Gurus" predicted the following:


1) Greatest retail and REIT stock rally in financial market history:



2) World record collapse in interest rates while debt is going up at record speed


3) Two consecutive crashes in the CRB Index during Quant Sleaze programs, POMO's, LTRO's, and Twists


4)  "Cult" retail stocks like Whole Foods and ULTA making historic record runs during the worst economy in 75 years and the biggest European crisis ever.




slewie the pi-rat's picture

that fearless, intelligent, handsome, bra-clad sell-sider~~ robo_T? 


gjp's picture

It really is just corrupt madness. The market goes where the pigmen want it to, as far as they retain control. It has zero connection to value now, and to suppose it will in the future is to suppose that the market will survive in some recognizable form when they lose control, which they inevitably will.

For now, it's all momentum, and it doesn't matter if they want to put a 40+ pe on a grocer growing 15% with already excessive margins on premium priced products in an over-retailed market where most of the rich neighborhoods already have locations. It's a cult stock as you say, value means nothing and the sky is the limit.

All while Rome burns away. Sickening.

bxy's picture

The biggest determinant of direction of any individual equity is the direction of the overall market.  Fundementals mean nothing in this bullshit, manipulated, house of cards.  Good luck with that.

Centurion9.41's picture

Oh how I loath the long only sell side sphincter muscles....

Were do we start?

VIX - To represent, over the long period displayed, market volatility via the VIX is utter garbage.  Why not simply chart ATR as a %?  Because it would not support the sales meme.

"Value" - really what is value?  Before a product outperforms, over a given period, the concept is no different than beauty; a very very subjective opinion. 

And oh yes, my favorite... "technicals" & "technicians".  Seriously, this is where what's jammed in this sphincter, beyond his orifice, is most clearly seen.  "Fundamental Analysis" IS in form and function almost identical to Technical & Quantitative analysis.  The ONLY functional difference is in the way the data is presented.   They all use mathematics to explain and display data. 

To claim P/E ratios and all the other "fundamental" mathematics is functionally different is utter garbage. 

If their vaunted fundamental/value analysis is so great, why do they have to spend most of their time explaining why reality did not match their math?

Seriously, if you can not see the utter idiocy and evil in this paragraph:

"This leads to the definition of risk. Unfortunately for many, the investment industry often operates on the premise that price volatility equals risk and is something to be minimized or avoided. This reflects faulty logic because price volatility is independent of risk. Seth Klarman of the Baupost Group properly defines risk as 1) the size of a potential loss and 2) the probability of its  occurrence. He refers to losses of a permanent nature (not volatility-related), and I would add that they need to be measured in real (i.e, after inflation) terms."

... then please, sit down, because I have something very important to tell you.  You are a member of that baying herd of Sheeple.

God do I hate the Wall Street marketing Zombies.

brainwashed's picture

I'm totally with you on this one and I have a CFA charter to boot. I can read financial statements as well as anyone in the world, but my fundamental issue is that all information that public gets is LATE. Someone already has received this information before the public does. Therefore, to analyze the value of a company using financial statements and future projections for me is absolute nonsense as someone has already done that and moved the price towards fair value in the process.

Caviar Emptor's picture

Only one thing matters for consistent returns when moving big money: how much of an insider you are. Only then can you minimize the chance of being ripped off by every middleman in the WS food chain and maximize the chance of knwoing what will happen before everyone and their taxi driver does. 

Otherwise technicals are no different than card counting techniques: "sure things" used to predict which card will turn up next

sablya's picture

That's where volatility and technical analysis come into play.  If you don't have all then there is no chance to make money in the markets.  You have to know what you want to buy and you have to be moderately close on when to buy it AND when to sell it. 

If there is no volatility then there is no opportunity.  I make money in the markets by buying when people are dumping (like UVXY today) and holding onto it until people are willing to pay me much more for it than I paid. 

I know UVXY is going to be worth more to someone in the future just because nothing has fundamentally changed in the world, and yet this "asset class" is being indiscriminately dumped.  Trash today, treasure tomorrow.  Volatility and timing of value purchases equals opportunity.


emersonreturn's picture

sablya, "...just because nothing has fundamentally changed in the world..."??  it seems everything is changing fundamentally?

Global Jackie's picture

But the value is not based on price. Agreed, the public gets inofmraiton late but if the public uses common sense investing; then, the value of a company should be ascertained via some rudimentary research. If you can't find the info you need, don't invest. 




SV's picture

You're assuming common sense - that's your first mistake right there.  Van Tharp puts it best, "You don't trade markets - you trade your beliefs about the market."  This is no where more true than the age-old debate between the fundamental vs. technical crowds.  Both skills are needed like hunting and cooking.  Just because you can bag your kill doesn't mean you can make a good stew or meal out of it.  Both skills are highly complementary.

SmoothCoolSmoke's picture

Only 3 letters can sum up the last 26 hours:  WTF? 

lolmao500's picture


IDF chief of staff-turned-vice premier: 'We are not bluffing'

Moshe Ya'alon tells Ari Shavit he is preparing for war. He suggests you do the same.

Bullish... war is good for the economy right? The bigger the better! Ask Krugman the genius!

impermanence's picture

Receiving more value than the price paid is theft.

jmc8888's picture

It's funny FDIC protection was never meant as a backstop for gambling in fraudulent products.   The separation of banks coupled WITH FDIC insurance is a sound plan.  But then with the repeal of Glass-Steagall the FDIC allowed the banks to use the gov't as a backstop for their gambling in fraudulent products. 

The answer isn't to get rid of the FDIC.  The answer IS to reinstate Glass-Steagall and separate the banks before the FDIC has to try and fail in coming up with trillions the banksters lost.  Even now they're broke.

But the banks, who control congress and the presidency, no matter the party, lobbied and bribed their way to an even sweeter deal than they had before the depression.

The author doesn't really understand that sometimes, certain aspects of laws were made to be in conjunction with others.  FDIC with Glass-Steagall, without Glass-Steagall, the FDIC is just a backstop for the banksters who hold deposits hostage.  It's sort of like in fight club where the lye burns your skin, but mix it with vinegar, and it's neutralized. 

The FDIC is important but it is critical when having such protection, that the banks are separated.  But hey Wall Street bought the best congressmen that fiat can buy, yet remember they had no role in setting the characteristics of what congress voted on, did they? Oh wait they DID.  Congress (or a gov't at large) that is bought and paid for is just another arm of Wall Street.



junkyardjack's picture

I'm glad the Daily Show covered this as well so that the average American can at least get a glimpse of what is going on in this country


bulldung's picture

Great advice, buy low.And the lesson the Eastman chart,sell high. Got it.

andrewunknown's picture

Take your troglodyte anti-technical arguments back to your cave, John. 

"MACD indicators"?  That's the analytical equivalent of saying the Earth is 6000 years old: why not try to develop some rudimentary, epsilon semi-moron-grade competence before you begin typing, ever again.   

"Tea leaves"?  You've probably been trotting out that facile little gem of an EMH straw man since those halcyon days when your intellectual infatuation with Fama began back in B-school.  Nice one.    

"But since short-term price moves [you don't define this, by the way] are unknowable, irrelevant and independent of investment merits" - No technician would argue that they're "knowable" - which blows your point of view to hell - and your categorical claims that they're "irrelevant and independent of investment merits" are intellectually indefensible.  Not that analytical prejudice can hear reason.

These poor technicians you deride, deluded and destitute, reduced to penury (after all, they're not in the Forbes 400) as they foolishly "guess" their capital away, "pursuing answers to the wrong question". Nevermind the inconvenient fact that there are many fabulously successful traders, asset managers, etc. who have run money using technical analysis all-but exclusively their entire careers.  Some trade short-term; others don't.  None of them would "apply leverage to their process and repeat it a few times in order to accrue hundreds of billions of dollars" because they - as you espouse - manage risk!  Moreover, they would argue - quite compellingly - that "price is everything" and that they use their "tea leaves" to exploit value...just like you.  Not the voodoo your random walk guru had you smoking back when you developed your analytical bigotry.

All that said, you, however, are an ideologically-steeped Bogle devotee zealously chipping away at the "right question" - which of course begs another question: for all your efforts, where the hell are you in the Forbes 400?

junkyardjack's picture


"Although there are certainly important exceptions, letter writing is often a beginning job in the industry, and as such may be handled by inexperienced traders or non-traders. Good traders trade. Good letter writers write letters." - Ed Seykota

eclectic syncretist's picture

Awesome post my friend.  Whichever Tyler wrote this is a real nub.  Should have just stuck to the point that the markets are more prone to intervention over the past decade or so, and that's been hard on technicians and fundamentalists alike.

Reese Bobby's picture

Hit a nerve did he?  You remind me of the saying "the bigger the words, the smaller the ideas"