There’s More to Risk Than Volatility: How to Invest Beyond Speculation
Most investors would love to be the next Warren Buffet, arguably the most successful investor ever, and yet many investors ignore his investment methods. Instead, they follow simple tricks and use simple definitions that miss undervalued stocks primed for growth. Successful investors such as Buffet take a broader view of investing and consider many commonplace investment ideas nonsensical, including the idea that and risk and volatility are one and the same.
The idea that volatility equals risk is easy to understand, the idea being that the more volatile a stock, the higher the chance that its price might fall. Unfortunately, treating risk as a simple expression of volatility ignores many other measures of risk that complicate the picture.
Value investors, such as Warren Buffet, look well beyond the simple notion of risk as volatility and use a combination of various numerical measures and company-level analysis to find undervalued stocks primed for long-term growth. For any investor wanting to look past stock-market tricks, value investment strategies are a great addition to their toolbox.
The Larger Picture of Investment Risk
Investing, whether in stocks, bonds or real estate, always carries some risk, but how to define risk still remains an area of debate among economists and investors. To many investors in the finance and stock market bubble, risk is synonymous with volatility. This leads investors to some odd conclusions. For instance, many investors end up chasing what they call risky stocks because these volatile stocks often belong to the most innovative and dynamic companies with the most potential for growth. However, just because a stock is volatile, it doesn’t actually tell an investor whether any particular company will hit it big.
The simple definition of risk as volatility is useful for economists tracking the stocks, derivatives and other investments in finance, partially because it is much easier to track than other more esoteric risk factors. Unfortunately, those more esoteric risk factors, such as management styles, worker productivity and company culture, are rather important to the long-term performance of companies that stocks represent a share of. Never mind even more unpredictable risks, such as disasters and disruptive innovation.
Looking for Companies with Value Instead of Stocks with Trends
Value investors following the Graham-Dodd school of investing take a much more all-encompassing view of risk and value, and their techniques are nothing to sneeze at. Warren Buffet became one of the richest people in the world by using value investing strategies, which is especially impressive considering he’s one of the few people to build his fortune on investing alone.
Buffet explained in one example, found by biographer Roger Lowenstein, that he could never understand investors that considered an undervalued stock risky simply because it is volatile. Volatile stocks in a low are a good investment to value investors like Buffet because volatile stocks in a low are likely undervalued and likely to rise again.
To value investors like Buffet, the company they’re investing in is where they look for value, rather than trying to follow market trends. Value investors look at concrete measures such as the price to earnings and price to book ratio. In addition, value investors judge for themselves whether a company is well run and whether the industry is well-positioned for potential future threats from innovation and socioeconomic cycles. Value investors often find these companies in places that other investors aren’t looking.
Markets are not perfectly efficient, at least not in the short term, but prices do generally come close to the true value of investments over the long term. Because of herd mentality, many investors end up following price trends and growth beyond the real value of investments, creating bubbles that are hard to resist but often leave investors in rough shape, such as the many investors that lost it all during the dot-com bubble and the late-2000s housing bubble.
Instead, value investors look beyond stock market trends in various places, including small companies and startups, unfashionable industries, and rising innovation primed for future growth. Value investors trust that by buying stocks from good companies they will win out in the long term when other investors finally notice the value of these undervalued stocks, leading to higher stock prices.
How to Be an Investor Instead of a Speculator
Many investors, following the false idea that risk is synonymous with volatility, give up entirely on picking the right investments, contenting themselves with simply trying to match the market by investing in ETFs. None of these investors will every match the likes of Warren Buffet.
Nevertheless, value investing does have its own risks, especially because it doesn’t spread the risk around. Even the best run unnoticed companies and startups with groundbreaking innovations can fail or continue to be ignored by the market. Temporarily unfashionable industries often come back, such as how the defense industry is often undervalued during peacetime and banks are undervalued during economic downturns, but not all industries come back. No system is stable forever.
There will always be a new place to find value, and always a new place to lose it. The key is to hunt for value outside the trends without being contrarian just for the sake of it. There’s a difference between investors who put their money into well-run, well-researched companies and investors that throw money at every new idea.
Following in the footsteps of value investors like Warren Buffet takes time. Value investing is a long-term strategy, and it requires experience and judgment built up during the process. For most investors, value investing strategies are a great tool to add to their investment and stock-picking toolbox, and if they spend their time doing the research they can prime their investment portfolios for long-term growth.