FOOL'S EYE VIEW
Volatility? Pah!

By Alan Oscroft
December 27, 2000

Liverpool -- We've just had four days with precisely zero market volatility here in the UK. Four days when the market was closed, that is. But here's a question: which would have been worse, four days with the market closed or four days of trading that saw the market go down and then back up to where it started again?

Both would have meant exactly the same as far as the value of the stock market goes, but the latter would have induced heartache, euphoria, and a host of other emotions in investors across the country. The former, to many of the same people, was just an excuse to drink too much.

David Berger talks about volatility in today's Rule Shaker, and volatility (or at least, its relationship to risk) is something that I like to rabbit about from time to time.

Volatility Isn't Risk

There are many investment theorists who enjoy doing calculations, and who sit in the halls of academia churning out all sorts of formulae relating share price volatility to market sectors, economic health, and the price of fish. And occasionally, one or two of them get Nobel prizes. Very few of them ever seem to get much in the way of success from investing in shares though.

Even without the numbers, the actual nature and importance of volatility is debatable. Some equate volatility with risk, and measure deviations of share prices from a theoretical straight line price appreciation, reckoning that greater deviation means greater risk. Others poo-poo volatility, insisting that it has got nothing to do with risk and that it is only fundamental company performance that matters.

Or Is It?

The truth (and the truth in most things usually tends to lie between the dogmatic extremes) is that volatility is a part of the risk equation, but the size of its contribution to overall risk relates to your investment horizon. For short-term investors (investors in telecommunications over the past couple of years, for example), sector volatility can make up by far the greatest part of their share price movements. But for people who bought British Telecommunications (LSE: BT.A) shares when the company first floated and held on to them, the actual improvement in the company's underlying valuation has played a more significant part in its share price journey, and that valuation is based on fundamental company performance.

The Longer The Better

The theoretical index tracker investor who "bought the market" back in 1918 (and yes, I know you couldn't actually buy index trackers back then), would have earned an average annual return of 12.3% less charges (and less any systematic negative tracking error). On a chart of the FTSE over that period it's hard to see the little wiggles over the years, and it is those very wiggles that make up the deviation, the thing that many theorists use as their sole measure of risk.

Since 1918, the increase in the real value of companies, brought about by the creation of actual new wealth, outweighs volatility as the main driving force of share prices by so much that it accounts for very nearly 100% of that driving force.

The same goes for individual companies too. Of all the public companies in existence back in 1918, many still exist in one form or another today. But many have gone bust, and going bust is surely an important risk. What is it that determines the risk of a company going bust or its likelihood of going on to long term success? Is it its underlying fundamental business performance or its short term share price volatility? The answer to that is easy.

Volatility Doesn't Matter

So I come to my usual conclusion, that share price volatility really doesn't matter. But it's a qualified conclusion. Volatility doesn't matter to the investor who:

• Is a genuine long-term investor.
• Usually behaves as though the stock market has gone on an extended Christmas holiday.
• Switches off from share prices and instead follows company fundamentals.
• Buys companies based on sensible, rational valuations and ignores hype and fashion.

If you're a short-term investor (and best of luck to you if you are, because very few people possess the ability to become successful in such a pursuit), then volatility will significantly affect your returns. And if you think you're a long-term investor but periods like the last few months have you reaching for your brown trousers, then think again -- maybe you're not cut out to be a long-term investor after all and should, perhaps, put your money in a tracker (or even in a savings account) instead.

Far From Dead

My last words for today are reserved for those people who, in times like these, trot out all those disingenuous criticisms along the lines of "Your long-term strategy hasn't worked very well over the recent short term, has it?". It is, in fact, the opposite conclusion that should be drawn from such volatile periods; that periods of high volatility reinforce the importance of the long-term ideal.

For a closer look at some of this year's most volatile companies and their sectors, cast an eye over The Motley Fool's Industry Focus 2001.

Where Next?

• Rule Shaker -- One Hell of a Year