The words risk and volatility have become interchangeable for most of the investing public. Many investors think volatility is risk, but that is not the case. Volatility is the variability in prices from one time-period to another, and consists of both negative and positive movements. Risk in investing is, by its simplest definition, the probability of losing money.
In exuberant markets participants tend to pay too little attention to risk. Then, when it is too late and the market tumbles, those same participants become much more risk aware. This is typical investor behavior. In fact, we should be thinking about risk constantly, no matter the state of the markets. Risk should be the number one priority, and market participants should think about it even more when markets are doing well. Historically, this is when risk (the probability of losing money) is at its highest level. When the market drops substantially there is much less risk – the market actually becomes safer. Most market participants see this in the opposite manner – that is, rushing in at the top rather than rushing in at the bottom. Risk should be at the forefront all the time, and as prudent investors we should always be assessing the probability of loss. Losses occur when a poor investing environment couples with built up risk. In general, we never know when this is going to happen, we only know the probability of loss is lower when prices are lower.
A great analogy for this is homeowner’s insurance. Everyone that owns a home pays for homeowner’s insurance to protect against damage, fire, etc… Come the end of the year, no one starts kicking themselves for having homeowners insurance they didn’t use. This behavior is simply a prudent action to protect against unforeseen risk. Similarly, investors should incorporate risk controls into their investment plan.
It is important to remember that much of the risk in stock investing comes in the form of other market participants, not the stock exchanges or a specific company. For many companies, the stock price is much more volatile than the underlying company’s results. Much of the risk lies in the behavior of those investing. Risk arises when many market participants take individually rational actions that result in irrational aggregate market outcomes. If all investors are overconfident then markets will surely be elevated and more risky. Conversely, if investors are fearful and over-selling, markets will be more attractively priced and less risky.
A discussion of market risk in times of euphoria brings to mind two quotes by the great Warren Buffet. Each and every investors should read these, digest the lessons they convey, and apply those lessons to every investment decision they make:
“The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
“Be fearful when others are greedy and greedy when others are fearful.”