How To Invest

Volatility vs. risk: The psychology of falling share prices

In a bear market, many investors worry about falling stock prices and that their hard-earned money will be wiped out in a crash. In a panic, some begin to sell their stocks at a loss. They convince themselves that it’s better to cut now than to see their investments fall further to the floor.

At this point, many investors essentially become short-term speculators instead of long-term shareholders. Due to their fear, they forget the original reason why they invest in a stock in the first place – which is to buy a great business and hold it over the long term.

Volatility vs. risk

Volatility is defined as the measure of how much the price of an asset fluctuates over time. For many investors, volatility is used interchangeably with risk. The more volatile an asset is, the ‘riskier’ it is.

But what exactly is risk? The dictionary defines risk as ‘the potential of suffering damage or loss’. So placing this definition in the context of financial markets, risk is about losing your capital.

So are volatility and risk still the same?

I find volatility to be an excellent proxy for risk for the short-term trader. Remember that volatility is a fluctuation of asset prices, and traders aim to make a profit on those fluctuations. Volatility offers the trader the potential for larger gains but also larger losses. In contrast, I would say that volatility is not risk for the long-term investor. Instead, the loss of capital due to the decline in asset value is the main concern for the long-term investor.

‘Price is what you pay, value is what you get.’ – Warren Buffett

It’s important to remember that price and value are not the same thing. A stock’s price can fluctuate wildly on a short-term basis, but its business fundamentals and intrinsic value can remain the same.

For example, Alphabet’s share price crashed by 30% in March 2020 when the COVID-19 became a global pandemic. But did Alphabet’s business evaporate by 30% overnight? No, it didn’t. Its long-term fundamentals remained largely the same and it is still the global leader in search and digital advertising today.

Benjamin Graham’s concept of the ‘margin of safety’ is a good way to think about volatility versus risk for the long-term investor. You have a margin of safety when you buy a high-quality asset at a price substantially less than its intrinsic value. In this case, you can effectively ignore short-term movements in stock price, knowing well that the true value of your assets is much higher than the market price regardless of volatility. You can effectively minimise the risk of value loss by leaving room for error and sufficient time.

Being long-term orientated, you should be a net buyer of stocks, especially when prices fall. Everybody loves to see rising stock prices, but bull markets and sky-high valuations are counterproductive when you want to focus on accumulating assets.

‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’ – Benjamin Graham

In a sense, volatility then becomes the long-term investor’s friend; it gives you the opportunity to accumulate assets at discount prices when volatile markets overreact to bad news.

Volatility and share buybacks

As a long-term investor, not only do you want to be a net buyer when prices are low, but if you invest in companies with high-quality management, those companies should also be net buyers of their own shares when stock prices fall. At low stock prices, companies increase shareholder value when buying back their shares.

Berkshire Hathaway’s ownership of Apple grew from 5.39% in 2020 to 5.55% in 2021. Yet Berkshire did not purchase any additional Apple shares during the year; Apple’s share buyback program took care of the task. Apple has retired 38% of its shares over the past decade. Companies like Apple that generate a large amount of free cash flow can take advantage from share price declines, allowing management to use the company’s cash hoard to buy back more shares as the price of the stock falls.

That is the great thing about owning a portfolio of high-quality companies that earn excess free cash flows. Your stake in a company can grow even when you do not invest any new capital. When it comes to buybacks, more shareholder value is created when the stock price of a great company declines.

Crises and gaining market share

Bear markets and recessions are also opportunities for well-run companies to gain market share. Pool Corporation is a company that, in my view, has a wide moat in the pool supplies and equipment industry.

Most of Pool Corp’s revenue comes from the home improvement category which is often considered a cyclical business. During the previous U.S. housing crisis, even though Pool Corporation sales volumes were heavily impacted, it also gained significant market share as most of its competitors are modest, local pool appliances shops which could no longer compete during an economic downturn.

As an industry leader, Pool Corporation can offer much better value to customers: lower prices, a greater selection, and more service locations. Pool Corporation is now the largest distributor of swimming pool supplies in North America, twice larger than its next largest competitor.

Even though Pool Corp saw slower growth amid the previous housing downturn, it also became stronger after the dust settled. If you are a long-term investor of a company that can gain market share during a crisis, you shouldn’t be bothered with the temporary volatility in stock price. Sometimes a challenging environment in the short term will lead to a larger market share and more earnings power in the future.

The fifth perspective

Volatility is not risk. In fact, volatility and drops in stocks prices are a great blessing for long-term investors who know what they’re doing. Every market crash, economic recession, or crisis brings new opportunities for the investor looking to buy great companies at discount prices.

Choon Leo Wang

Choon Leo is a growth-focused investor with an interest in innovative platform businesses that connect users and fix market inefficiencies. He believes that companies with the most competitive business models will compound in value over the long term. He currently holds CFA Level I qualifications.

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