On Volatility, Risk and Popping the Cork

There is a debate in the wine industry about the cork.  Traditional, romantic and symbolic, popping the cork has long signaled the start of a celebration.  The problem with the cork is that it is not that good at what its primary task—sealing a bottle of wine.  Modern screw caps are far superior in this regard, yet the cork endures.  Why?

The cork endures because its secondary task—providing a pleasurable and ritualistic moment—is just as important as its ability to seal a bottle.  People enjoy uncorking a bottle of wine the same way they enjoy putting on a vinyl record or working in a garden.  In the cork, we have one tool that fulfills two needs—the desire to experience ritual (at which it is great) and the need to seal a bottle (at which it is OK).  The cork’s versatility results in its survival.

In the financial world, volatility tries plays a similar role.  The cork combines two roles into one, and so does the concept of volatility as risk.  There are two types of investing risk:  fundamental risk and liquidity risk.  Fundamental risk is the uncertainty in the the economics of an investment.  Will Apple meet its earnings targets?  Will GM default on its bonds?  The second type of risk is liquidity risk.  Will I be forced to sell my Apple shares due to a need for cash?  Volatility is one measure that has traditionally  encapsulated these two vastly different types of risk.

However, while we can forgive the romantics for their love of the ritual of opening a bottle, we cannot forgive financial theorists for intermingling two distinct types of risks into one measure.  Volatility is and will always be a misleading and potentially damaging measure of risk.  Not only does it lead investors to ask all the wrong questions, it encourages them to value all the wrong information.  They look at historical price fluctuations rather than current financial statements.  They look at head and shoulder patterns rather than their own cash flow.  Sadly, this is encouraged because it has been easy.  Solid tools have been lacking to ground the investor in the economics of a business—tools that help and investor separate fact from speculation.

At Prudena, we have recently launched two tools to help investor.  The first is an Implied Growth Rate Calculator which does a back of the envelop calculation on how much speculative growth is priced into a stock.  The second is a Margin of Safety Calculator which looks at the financial statements of a company and earnings estimates to do a rough calculation on the rate of financial return for a stock given an investor’s required return.  Neither of these tools is intended to provide answers.  Rather, they are intended to equip and investor to challenge the market price.  Taken together, the tools are a starting point for fundamental risk management.

So, the next time you are at a cocktail party and someone starts talking to you about volatility as risk—and some fancy formulas to exploit this—lookNext page› down at your glass of wine.  Remember the cork and how it can serve a dual role.  But also remember that evan though volatility as risk is a tradition, it is no cork.  It is not strong enough to play the dual role that it has been given.  Smile, have another sip, and remember that rollercoasters are safer than cars if you don’t have to get off in the middle of the ride.

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