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Risk, Volatility, and Uncertainty: 3 Distinct Investment Concepts
Risk, volatility, and uncertainty are three terms that are often used interchangeably by stock investors. They all kind of sound the same, so what's the big deal? Why separate them into individual definitions? Why do I have to be Buzz Killington all the time?
It turns out that having a distinct definition for each of these concepts—and keeping them very compartmentalized in your brain—can help a great deal when identifying how likely you are to lose money.
Charlie Munger's prescription for success in life is mainly not to do anything especially stupid and to generally avoid doing the wrong things. His partner, Warren Buffett, puts it more succinctly: don't lose money. Follow Buffett's rule number one (coincidentally also rule number two) by understanding the important distinctions so you can apply all three concepts to your portfolio, helping to maximize your long-term returns.
Now, these are my own personal definitions of these three words, and while you might split hairs by interjecting, "Actually, . . . " it's not important to me what you call these things—just that you have an idea that there are three distinct concepts to understand and to put to use properly. Let's dive in.
What Is Risk?
Let's start with risk. Of the three terms we're discussing, risk is almost certainly the first word you became comfortable using widely, and we all have some idea of what engaging in risky behavior looks like.
For the purposes of investing, let's define risk the way Seth Klarman, Buffett, and Howard Marks do: the likelihood of permanent loss of capital. This means you're not going to be able to get your money back from your investment, so if you buy a stock, your risk is whether you might lose money on the deal. However, there are a few ways you might not end up getting your money back:
- The company could go bankrupt, the stock could go to zero, and you could be completely wiped out (it's worth noting that stocks going all the way to zero isn't a particularly common occurrence, but it can happen).
- The company could undergo some turmoil, and never again rise above the level at which you bought the stock (this is much, much more common).
- You might be forced to sell a stock at a loss in order to pay for something else.
- Your money could be stolen.
This is by no means a comprehensive list, but you get the general idea: You don't get your money back, and you permanently have less money as a result of this investment. Risk is defined by this property alone.
What Is Volatility?
Volatility is often an academic stand-in for risk (permanent loss of capital), but the two are definitely not the same. A trio of Nobel-prize-winning economists (Markowitz, Sharpe, and Miller) helped develop the Capital Asset Pricing Model (CAPM) by introducing an idea that really rubbed Warren Buffett and company the wrong way.
The idea was that the amount by which a stock's price goes up and down over a given period of time is the only factor you need to consider in order to determine whether a stock is a good investment or not, and the risk/reward ratio, the crucial important any investor has to consider, could be determined by this fluctuation.
It's certainly possible for you to have to sell a stock if it drops a lot (experiences volatility), especially if you're levered up (borrowed against your portfolio) in order to own the more volatile stock. A portfolio can dip a lot and lose market value, and your broker might be triggered to ask you for more capital to cover what they're owed; if you don't have this cash, they can then sell your stocks in order to cover their costs.
This happens a lot if you're shorting a stock and it goes to the moon, too (my solution: don't short anything, but your solution need not be so extreme in order to protect yourself from permanent loss).
It's important to remember that you're only going to experience a permanent loss of capital (the consequence of risk you really want to avoid) if you sell a stock when it's down. Why would you sell when it's down? Well, if your stock story has changed (if you found out the company's books weren't what you thought they were, or if people are no longer using the product or service the company makes, etc.), then it might be time to sell, but if the stock is down simply due to the sentiment of Mr. Market, you can just buy more of the business while it's cheap or just hold on to what you have and wait for your the market to chill out.
The main takeaway here is that volatility is not risk, and just because a stock moves up and down more than another one does, does not mean that the former stock is riskier than the latter.
What Is Uncertainty?
Uncertainty is a concept that is quite far removed from both risk and volatility, and it sort of governs the other two concepts (or at least describes aspects of them). Investors often avoid investments they perceive as risky, but in some cases, they're really wrong about this assessment.
Imagine a stock with a very limited downside. Maybe it's a company with a billion dollars in tangible assets selling for a billion dollars; so if you buy the stock and then the company is liquidated (Klarman and others call this a "net-net" situation), then the theoretical worst-case is that you break even.
However, the upside is very much unknown. Maybe the stock is likely to double over the next year, and you think there's a pretty good chance of that happening. Your stock is so much cheaper now than it was a few weeks ago, but Wall Street takes one look at this stock and doesn't particularly like it. Why? Uncertainty.
There's a certain type of company that Wall Street really does love. It's the type of company that can tell you within a very close range how much money they're going to make next year and then the year after that (they "issue guidance," in the parlance of corporate America), and analysts agree with the guidance, since they've been reliable over time.
This stock is perceived to be "less risky" than the one above, where you have absolutely no possibility of losing money but a very good chance to double in a year. This is not for you. You're interested in the former, and if you have a collection of such companies, you're almost certainly going to have vastly better returns than a collection only consisting of the former type of company.
In short, as Monish Pabrai is fond of saying, don't confuse risk and uncertainty. Volatility, on the other hand, is really just short-term uncertainty, and this shouldn't bother you in any meaningful way (other than looking for great opportunities to sell or buy if the price is right).
The Importance of Compartmentalizing
Language is a funny thing. We often say one thing, and the person sitting across from us hears an entirely different thing and vice-versa. Because of this, having a very clear, consistent definition in your own mind is crucial when applying these concepts to money management.
By making sure you compartmentalize volatility and uncertainty, which can be really good friends to the intelligent value investor, far away from the realm of risk (which can be really bad), you can help your mind to assess the situation much more clearly, helping to ensure that you aren't panic buying or selling, and—most importantly—you can avoid a permanent loss of capital.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.