Please help my son...very basic question

[DesertCat]

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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.

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Stop being coy.

I'll just quote Burton Malkiel from those very same pages in Random Walk (2003 edition). " It appears there is no relationship between returns for stocks or portfolios and their beta measures of risks...
Beta, the key analytic tool of the capital-asset pricing model, is not a useful measure to capture the relationship between risk and return."

And even if someday academics were able to prove higher beta stocks offered higher returns, it wouldn't change what I'm saying. Beta is not a measure of risk, it's a measure of opportunity. I would make my choices based on a direct measure of unsystemic risk, i.e. business risks. Whether they are volatile or not, won't matter to me, the volatility will just offer me opportunities to buy and sell them at attractive prices.

[ISF]

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" It appears there is no relationship between returns for stocks or portfolios and their beta measures of risks...

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No one really ever believed beta vs. some stock market index would price stocks. It was just a simple theoretital model. The beta was supposed to be vs the golobal portfolio of all investable wealth which one cant observe. Covariance with things like human capital and real estate will never be able to be measured but covariance with them is risk.

That being said I seriously cant believe someone that ivests for aliving cant understand how systematic volatility is risk. It is not that complicated. It does not matter that the cash flows of the business have not changed when the stock goes from $10 to $5 you still lost $5.
So what if the expected return is now higher. When all stocks go down which happens all of the time everyone invested in stocks looses money. Money which they couuld now invest in stocks which would have a higher expected return then when they initially invested. Do you not think there is interest rate risk in a long term bond? The concept that systematic volatility in stocks is risk is no different then understanding that there is interest rate risk in long term bonds.

[DesertCat]

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That being said I seriously cant believe someone that ivests for aliving cant understand how systematic volatility is risk. It is not that complicated. It does not matter that the cash flows of the business have not changed when the stock goes from $10 to $5 you still lost $5.


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No you haven't. You only lose money if you sell.

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So what if the expected return is now higher. When all stocks go down which happens all of the time everyone invested in stocks looses money. Money which they couuld now invest in stocks which would have a higher expected return then when they initially invested.

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I buy a stock A at $10 with an expectation of a 12% annualized return for the next 6 years, i.e. that I will sell it for $20 in 6 years. I chose this over stock B, that is also selling for $10, because I think B will only be worth $15 in 6 years (7% annualized).

Tomorrow the stock market goes haywire. Both stock A & B are trading for $5. A is now offering a 24% annualized return for the next 6 years. Why would I be depressed I can't redeploy it in B, who's annualized return is still only around 14%? If A & B decline similarly, and A was the better investment, I'm happy holding my investment in A. If B declines more, below $3.75 per share in this example, it begins to offer a higher future return. At that point I'm very happy to sell A, take a valuable tax loss, and redeploy the funds into B to get higher future returns.

Either case, my eventual expectations are either the same (A remaining the best investment) or even better (B gets even cheaper). For example, if this was a $1000 investment (100 shares of A), I had expected to get $2000 in six years. If I'm able to trade my 100 shares of A for say, 140 shares of B, now my expectation is now $2100.

Of course, if I had ESP, and had waited until tomorrow to invest, I'd be happiest of all. But investing isn't like that, I can't predict when I'll be offered the greatest possible bargains, I can only choose whether I take the bargains offered to me today.

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Do you not think there is interest rate risk in a long term bond? The concept that systematic volatility in stocks is risk is no different then understanding that there is interest rate risk in long term bonds.

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There is no risk of loss of capital in long term government bonds if you hold until maturity. Similarly with stocks, you are much better suited to deal with volatility if you buy businesses you will be happy owning for very long periods of time. Long periods enable a growing business to increase profits, sales, i.e. value, and increases the likelihood the market will eventually catch up to true value.

Remember that we are talking about volatility risk here, not business risk. If A declines to $5 because fundamental changes have damaged it's business or you made a mistake in analysis, it may not be worth even $5 at that point. But in the cases where you are convinced your analysis is correct, and the business is still performing as expected, lower prices are a wonderful opportunity to put more cash to work to increase your future returns. Even if you are fully invested, often you will have additional cash flows from dividends, or savings from your regular income you can put to work.

[ISF]

I dont understand why this is so complicated. Your are assuming somehow the time when people get money doesnt matter to them. It does and this is why volatility matters. I understand Buffet wrote in some book that volatility was not risk. He does not really believe that. He just understands that while returns increase linearly over time volatility only increases with the square root of time so most long term investors would be better off not freaking out when stocks go down. He understands it is more complex then this, but the main point of his books is to help people correct their biggest investing mistakes one of which is moving in and out the stock market at specifically the wrong time. You should worry about the risk in the context of your expected holding period, but you should still worry about it.

It does not matter that a you will always get paid holding a long term govt. People dont have these descrete time frames where they want money. If interest rates go up they lost money because they could now invest it at a higher rate or becuase they cant use it to consume as much now. That is risk. The same is true for your stocks. When all stocks go down you lost money that you could have invested for a higher rate or return or could have sold, but now cant. If all people cared about was expected return they would foregoe all consumption and invest everyting in a levered stock portfolio. Over a long time horizon it isnt that risky. People dont because they care about being able to access their wealth over different points in time.

[DesertCat]

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I understand Buffet wrote in some book that volatility was not risk. He does not really believe that. He just understands that while returns increase linearly over time volatility only increases with the square root of time so most long term investors would be better off not freaking out when stocks go down. He understands it is more complex then this, but the main point of his books is to help people correct their biggest investing mistakes one of which is moving in and out the stock market at specifically the wrong time.

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Warren Buffett doesn't write any books, his quotes are from public appearances or his shareholder letters. And he doesn't dumb down what he says for any audience, he gives you his straight opinions.

This is what Warren Buffett really thinks about volatility. It's a story about "Mr. Market" that pretty much explains what value investing is all about.

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It does not matter that a you will always get paid holding a long term govt. People dont have these descrete time frames where they want money.

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I think one of the issues we are having communicating is you keep worrying about "wanting the money". To be a successful stock market investor, you need to make a long term commitment. You can't be putting rent money into stocks, because volatility can easily produce a loss before your landlord knocks next on your door. If you invest with money that you won't need for at least a decade, not only can you ride out short term volatility, you can benefit from it.

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If interest rates go up they lost money because they could now invest it at a higher rate or becuase they cant use it to consume as much now. That is risk. The same is true for your stocks. When all stocks go down you lost money that you could have invested for a higher rate or return or could have sold, but now cant.

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This is where you get off the tracks. If all the stocks in the market go down equally, the most attractive stocks still offer the best returns. There is no need to sell one stock for another, unless the other is offering a higher future return. You can't say I lost money because I could have bought cheaper today then yesterday, because that implies you have perfect knowledge of future events. If that was true, volatility would really be your friend.

But if you buy a company that is going to grow it's net worth by 20% a year, and it gets cheaper, that's not a cause for worry. Buy more if you can, otherwise be patient. Every day the company will be compounding that value until Mr. Market notices and rewards you.