Risk - Volatility

Most people think of risk as volatility. The more a security swings around, the more risky it is believed to be. We simply do not agree with this. Just because human beings are emotional and freak-out and sell causing prices to go down, or get greedy and buy with no regard to price or value, has nothing to do with risk. Volatility, for the most part, is caused simply by human emotions of fear and greed.

We define risk as the probability of incurring a permanent loss of capital. For example, consider a biotech company going through the FDA approval process with everything riding on the chance of one drug getting commercial approval. If the company is denied approval, it is likely the company is worthless and we could lose all of our capital. We may not be able to peg the exact probability of a permanent capital loss, but let's say it's 30-50% in this example. In another situation, we have a manufacturing company trading at a significant discount to a conservative estimation of its liquidation value. In this case, even if the company has to shut down or go bankrupt, the price is such that stockholders would still come out ahead from these levels. In the case of the manufacturing company, the probability of permanent capital loss is likely 0%. Therefore, the manufacturing company trading below liquidation value has much less risk than the biotech company dependent on FDA approval, regardless of which one is more volatile.

Volatility does not make something inherently riskier (i.e. an increased probability of a permanent capital loss). In fact it can often make it less risky. Let us explain: If you have a stock that you think is worth $100 and it trades from $80-$120 in a year, the best price you can pay is a 20% discount ($80/shr) to its intrinsic value. If you have the same stock and it trades from $60-$140 in a year the best price you can pay is a 40% discount ($60/shr). Given the second situation has more “volatility” (it moves around more) it would be considered riskier by traditional risk metrics. However, let’s assume you were wrong on your intrinsic value estimate and the stock is only worth $70 instead of $100. In the first situation you would lose money if you bought near $80 and in the second you would make money if you bought near $60, despite being 30% wrong on your valuation. Therefore, the higher volatility provided an opportunity to buy at a larger discount to your intrinsic value, giving you a larger margin of safety.