Please help my son...very basic question

[gull]

Volatility is essentially risk in the short term.

And volatility can be a very good thing when it causes stocks to be more undervalued or more overvalued.

[SmileyPSU]

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desert,

have you ever actually had an original thought about investing, or could you be replaced by a bot programmed to quote semi-relevant sections of buffett's writings?

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Wow there have been a couple of attacks on respected posters in this thread.

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I agree. This forum is a bit more civil than the rest of 2+2 and personally I like it that way. Please try to disagree in a more constructive way in the future. [img]/images/graemlins/smile.gif[/img]

Krishan

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I apologize if I was blunt in my disagreement with Scorp/DC but I want to 100% clarify that I was not bashing DC. He adds more to this board and provides better advice than anyone else here. He's a wonderful resource for the people who read this.

[Scorpion Man]

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Volatility is essentially risk in the short term.

And volatility can be a very good thing when it causes stocks to be more undervalued or more overvalued.

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What is the guts of your point, Gull? If you like a volatile stock because it will go down with high probability at some point the...WAIT! And buy it cheaper! Why buy now with such high chance its lower later? Voila. If everything thought that way, then...the stock would be lower on average.

This B.S. about volatility being a good thing because you get better prices is just that..B.S. When a stock goes down for no good reason and you don't own it, that is an opportunity. When a stock goes down and you own it, you would have been better off waiting. THere is nothing good about it. The fact it might be a good buy now does not do anything to say the orginal buy was good. It wasnt.

I want to be clear. I am not saying don't invest in volatile stocks. I am not saying that volatility does not create opportunity. I am saying that theories that won people nobel prizes are based on risk aversion. Risk aversion is very well documented in academic studies...you cannot just do away with the relevance of risk because you think you "know" the true value of something.

[Scorpion Man]

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IF everything were always "Fairly valued" why would you need to accept more volatility to make money? I don't understand.

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You want me to explain a theory I find absurd? Okay, let me do my best. I think wikepedia does a good job of explaining that higher returns are the reward demanded by investors to take higher risks. I believe that, as well. I just don't define risk the same way. The EMT explains it as higher volatility (their definition of risk) equals higher returns.

So if stock A has higher volatility than stock B, it will be priced to offer higher returns than stock B. Both are "fairly priced" not because they offer identical returns, but because they offer fair returns for their relative risks.

http://en.wikipedia.org/wiki/Efficie...cient_frontier

But you can have an extremely risky investment that has almost no volatility. Assume there is a publicly traded stock for a company (trading as C) that will go out of business in one year. It's an extremely liquid stock, with 1B shares outstanding and the company is healthy, with $1B in cash in a (non interest bearing account) with no liabilities. At the end of that year, it will either payout $1 per share (paying all remaining cash to investors), or $0 (paying all remaining cash as a pension to it's greedy CEO), before closing it's doors forever. The decision on the payout will be made by the board via flipping a coin, so it's exactly a 50-50 proposition that can't be predicted ahead of time (no inside information or hidden risks).

Clearly the EV of each share of stock is 50 cents, one year from now. Due to the time value of money, the stock will likely trade at some discount to that value, say 5 cents, a discount that will slowly diminish over the year. Due to the liquidity it's reasonable to expect that C will trade very closely to it's correct value, probably within a few tenths of a cent, because of arbitragers who will short or buy it if it goes out of it's range to capture any excess returns.

So it slowly creeps up to the 50 cents level the day of the judgment. According to EMH, this lack of volatility creates a low beta that makes it an extremely safe investment that is offering a low return. According to rational thought, it's an extremely risky investment that is offering a very high potential return because it has a 50% chance of being worth zero the next day.

I prefer to think rationally about the risks in my investments and handicap accordingly. I demand a higher return for greater business risks, not for volatility. Volatility can be recovered from, bankruptcy often cannot.

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These stocks exist. They are called biotech stocks. And, while they often trade in a narrow band and relatively low volatility in the months going into an announcement, the options market gives visibility into HUGE volatility. The market is very good at recognizing this. Volatility has an element of time...your investment, looked at with ANNUAL volatility, has huge risk. It's all a question of time frame. Options on the security you describe would be priced accordingly.

FWIW I dont not believe the security you describe would trade anywhere near as tight as you describe unless there were derivative instruments to create arbitrage opportunities. I have seen many more certain situations than that trade at wider spreads to fair value than that. Its unhedgeable, people are risk averse, and noone looks around looking for single coin flips with a 50.3% edge.

[Scorpion Man]

By the way, DC, I also appreciate your willingness to engage in spirited discussions on all of this stuff. I just like to argue my points strongly...that is what they teach you at Harvard Business School...it does not really matter what you say...just say it like you mean it.

[DesertCat]

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By the way, DC, I also appreciate your willingness to engage in spirited discussions on all of this stuff. I just like to argue my points strongly...that is what they teach you at Harvard Business School...it does not really matter what you say...just say it like you mean it.

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I don't mind at all. If I sometimes repeat myself or go on to long, it's cause I figure the better I can explain my process and opinions, the easier my mistakes can be challenged. I'd rather find out I'm an idiot here than after I screw up one of my investments.

[iversonian]

Re: DesertCat's example of an extremely risky investment with almost no volatility

That case simply illustrates the shortcomings of a quantitative measure of beta based on trailing price history. Of course, blind number crunching on a single stock is no substitute for common sense. In the aggregate, stocks do not conspire to screw over anybody using any particular model of their behavior, and no quantitative model is intended to make a definitive judgment about any particular stock. If the top decile beta stocks outperform the bottom decile stocks consistently (do you dispute this?), then that right there suggests it's not worthless.

[Guppies]

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If the top decile beta stocks outperform the bottom decile stocks consistently (do you dispute this?), then that right there suggests it's not worthless.

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Excuse my ignorance please. I am new to investing and just trying to gain as much information as I can. Currently I'm reading "A Random Walk Down Wall Street" and in that book Burton Malkiel cites a study published in 1992 conducted by Eugene Fama and Kenneth French that indicated that this wasn't true. The study analyzed stocks performance by beta decile between 1963 and 1990 and found no correlation between the two. So... I guess I dispute what you're saying?

[iversonian]

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Excuse my ignorance please. I am new to investing and just trying to gain as much information as I can. Currently I'm reading "A Random Walk Down Wall Street" and in that book Burton Malkiel cites a study published in 1992 conducted by Eugene Fama and Kenneth French that indicated that this wasn't true. The study analyzed stocks performance by beta decile between 1963 and 1990 and found no correlation between the two. So... I guess I dispute what you're saying?

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Looking at that same chart, and the top decile does in fact outperform the bottom decile. It may not be significant -- we can't conclude anything from this one chart -- but it doesn't contradict what I said.

[Guppies]

A cursory google search turned up the following chart which seem to be in direct conflict with the assertion that higher beta equals higher returns. The image is a chart of the 600 largest stocks in the US from 1963 to 2006. The stocks are split up by decile (with the 10 group corresponding to the 10% of stocks with the highest beta). As you can see, this chart actually shows that the stocks analyzed over this period trended towards a lower rate of return as their beta increased.

I'm not sure I've ever heard of a negative correlation between beta and returns and I don't really see how this could be true, however the chart seems to indicate that it is.




The image was found here. http://donmihaihai.wordpress.com.

Although I can not scan the actual chart found in "A Random Walk..." I am looking at it right now and it also shows no positive correlation between higher beta and returns. And although you're correct that the highest decile on that chart outperforms the lowest decile, it also true that the second lowest decile outperforms the highest decile. This would seem to indicate that their is no connection between beta and returns (or at least that the connection implied in your post does not hold).