Volatility is a force within the market that can either hinder or assist in the success of an investment. Volatility refers to the fluctuation of a stock price. The more stock prices fluctuate, the more volatility is associated with the security. In modern finance, risk is heavily associated with volatility, and it is assumed that a more volatile security is riskier.
However, value investing teaches us that volatility itself is not inherent risk within a security. Value investors focus on the underlying value of a security, considering what the company is worth. If a company’s stock price drops but the underlying fundamentals remain the same, then the security has actually become a better deal, increasing its intrinsic value per share.
Value investors should not be daunted by market volatility. It’s crucial to understand that markets aren’t always efficient, and they frequently move due to reasons unrelated to the actual business developments of individual companies. Markets can sway due to various causes, ranging from macroeconomic factors like changes in GDP numbers to fluctuations in interest rates. When such volatility impacts an investor’s portfolio, it’s imperative to conduct a bottom-up analysis of the owned securities. Doing so anchors them in their original investment rationale, preventing them from getting swept up in the macroeconomic upheavals of the moment.
An investor’s role can be likened to that of a gardener. While gardeners cannot control the weather, they meticulously care for the seeds they’ve sown, hoping the conditions will favor a bountiful harvest. Similarly, investors might not have direct influence over broad economic forces, but they can strategize in anticipation. Just as a gardener might choose seeds based on predicted weather patterns, investors can base their decisions on economic forecasts, enhancing the likelihood of fruitful returns.
Value investors can take advantage of volatility by utilizing temporal diversification. This strategy involves spreading stock purchases out over periods of time to prevent overexposure to stock fluctuations and being caught in a downtrend after a purchase. Temporal diversification allows investors to average up or down into a security, giving them time to learn more about the business and take advantage of fluctuating stock prices.
Individual investors have a distinct advantage in practicing discipline through temporal diversification. Unlike professional investment managers who often feel pressured to generate ideas swiftly to outperform due to their fee structures, individual investors don’t face the same urgency. This freedom allows them to deploy their cash more patiently, rather than feeling compelled to be fully invested at all times. This patient approach offers protection from immediate significant price drops that can occur after an initial purchase. Additionally, by spreading their purchases across different time periods, investors can guard against systemic risks. For instance, during market downturns that might decrease the price of a security when the broader market is overvalued, this strategy provides a cushion. In essence, temporal diversification and averaging into securities can serve as a strategic approach for individual investors, helping them navigate the challenges posed by increased market volatility.
On the other hand, investors also face the challenge of dealing with a lack of volatility. This occurs when investments seem to languish, with no significant price drops that would turn the security into a greater bargain, and no upward volatility to outperform relative benchmarks. The lack of reassurance that an investment thesis will come to fruition can lead to a frustrating holding period.
Lack of volatility in stock prices, or even stagnant business performance, can significantly impact an investor’s psychological well-being. It’s a common jest that value investors often arrive early to the party. This means they recognize a valuable asset, but it might take a considerable amount of time before its true value is realized in the market.
Moreover, a company might be performing exceptionally well operationally, but this may not be reflected in its share price immediately. This lack of immediate price reflection can be disheartening. Additionally, the absence of volatility translates to a lack of stimulation, which can be challenging for novice investors. Business conditions often need time to evolve to a point where a long-term investment thesis becomes evident. Herein lies the importance of patience as a hallmark of a successful investor. In many cases, holding onto a security for extended periods, without frequent trading, can yield the best returns.
To combat the monotony of a non-volatile market, investors should seek intellectual stimulation elsewhere. This can be achieved by exploring new investment ideas or monitoring potential ones. It’s not uncommon for a company to be recognized as a promising investment, only for a significant duration to elapse before it’s opportune to buy its shares. To navigate this, maintaining a database of potential companies, routinely reviewing possible investments, and scouting for fresh opportunities are all effective strategies. These methods address the challenges posed by a lack of volatility without necessitating frequent trading.
It’s imperative for investors to perceive stock purchases as business acquisitions. Reducing the frequency of stock price checks, viewing stocks as tangible businesses, and emphasizing the generation of new ideas over daily market fluctuations are all pivotal strategies. These tactics can help mitigate the anxiety stemming from stock performance. Investors must recognize that most stock theses require time to manifest, often spanning 3 to 5 years. Hence, cultivating patience and adopting a long-term perspective are essential in managing the challenges of volatility, or its absence.
How investors handle periods of underperformance, not just in a specific stock but across their entire portfolio, can significantly influence their long-term success. Understanding one’s emotional and rational responses during stressful times is crucial. This sentiment is even more pronounced for investment managers who must communicate with clients frustrated by underperformance relative to benchmarks or other managers.
Position sizing plays a pivotal role in managing volatility and overall performance. Investors who become overly stressed by portfolio losses, especially substantial ones that most long-term investors encounter occasionally, should consider adjusting their strategy. If they find themselves deeply affected by these downturns, it might be prudent to adopt a less conviction-driven approach. This involves limiting the percentage allocation of each position within the portfolio, thereby reducing the potential risk associated with each security. However, this approach has implications. Holding more securities, each with a smaller portfolio percentage, means that more successful investment ideas are needed to make a significant impact. This increases the number of investments to be selected and monitored, leading to more positions to track and, logically, reducing the chances of outperforming.
Professional investors, especially those concerned with relative performance, often have teams of analysts at their disposal. To achieve a less volatile portfolio, they might opt for high diversification. When executed diligently, this strategy can yield attractive risk-adjusted returns. However, this is just one method to navigate volatility.
By truly understanding and embracing price volatility, and recognizing the advantages of a long-term perspective, savvy investors can adopt a more conviction-based portfolio approach. This involves placing greater emphasis on their highest-quality ideas and maintaining a long-term mindset of at least 3-5 years. Such an approach offers a significant competitive edge against investors who are constantly seeking numerous new ideas while remaining wary of volatility.
Accepting periods of underperformance as temporary fluctuations and effectively communicating the long-term investment strategy, either to oneself or to clients, can have a profound impact on portfolio returns. It’s essential to recognize that periods of underperformance are a potential outcome of a concentrated portfolio. While it’s not guaranteed that every portfolio will experience these downturns, many investment partnerships have demonstrated the ability to outperform the market consistently. However, it’s equally important to acknowledge that the potential to outperform also comes with the risk of underperformance.
Occasional years of underperformance are not inherently detrimental to the success of individual investors or investment managers. What truly defines their success is how they navigate and respond to these challenging periods. The manner in which they handle underperformance ultimately determines their effectiveness as stewards of capital.
Handling periods of outperformance can be just as psychologically challenging for investors as underperformance, but for different reasons. Investing often involves delayed gratification, where you are rewarded for past decisions. When an investor experiences a series of successful investments, positive reinforcement begins to take effect.
Overconfidence in one’s decision-making can lead to sloppy risk management, while muscle memory might cause investors to cling to methods that are becoming outdated. Investing is about exploiting an opportunity until it’s no longer available. Successful investors often pivot their strategy right when it seems to be working the best. This is because investing is a forward-thinking exercise. Logically, any good hunting ground can become a lousy one after it gains the attention of other hunters. Having a first-mover advantage is crucial for investors, but it’s challenging to adopt if one’s current strategies are working well.
Another adverse effect of outperformance is hubris and arrogance. This can be bothersome when affecting individual investors but can be downright dangerous when seen in investment managers. Periods of outperformance often come with substantial incentives for investment managers, as well as recognition and praise from clients and enthusiasts. It’s common for an outperforming investment manager to be elevated to a guru status. Their macroeconomic insights are highly regarded, their investment positions are emulated, and significant contributions start pouring into their operations. Feelings of euphoria can take over, especially with peers reinforcing their successes. During such times, investors are eager to discuss relative performance, share portfolio statistics, and offer insights to budding investors seeking advice.
An investor, and especially an investment manager, must ground themselves in humility if they want the best chance to outperform over the long term. It’s fulfilling to be recognized for hard work and even more rewarding if it brings value to clients. One vital practice is to invert the feelings associated with outperformance to those of underperformance. For instance, would one be comfortable sharing returns after consecutive years of underperformance? Would one discuss portfolio positions if they are at a loss, or confidently discuss a strategy if it’s currently out of favor? Such introspection can help investors maintain focus and avoid the distractions and self-destructive tendencies that accompany outperformance. Just as flows of praise and contributions can accompany outperformance, criticism and redemptions can follow closely behind. Understanding how to navigate these periods is essential for successful investment management.
Volatility is a defining characteristic of financial markets. In modern finance, it’s often equated with risk, potentially clouding the judgment of professionals when assessing the viability of investment strategies. A genuine value investor, however, welcomes price volatility while maintaining an unwavering commitment to thorough fundamental analysis.
Such an approach enhances the probability of investment success. It acknowledges that volatility does not inherently represent risk; rather, it introduces less predictability in outcomes. Investors with a long-term horizon can leverage this volatility, using it to their advantage to capitalize on price fluctuations. On the flip side, it’s crucial to recognize that periods of low volatility bring their unique challenges.
Understanding that volatility is an intrinsic part of investing in public markets is essential. Being overly fearful of it or excessively exhilarated by its prospects can lead to undesirable outcomes. Regulating emotions becomes pivotal for the success of any investment venture. Establishing internal checks and balances can help maintain an investor’s psychological equilibrium, ensuring that decisions are made rationally and not purely on emotional impulses.
If the idea of volatility or a temporary capital loss is intolerable, then delving into the capital markets might not be the best choice for certain individuals. Every investor has unique traits and circumstances, affecting their efficacy in executing an investment strategy. Some of the most accomplished investors have weathered the stresses of underperformance, only to rebound with consistent outperformance as their investment hypotheses materialize. Equally vital is the ability of these successful investors not to become arrogant during prosperous times. They recognize the highly competitive nature of investing and remain aware that periods of underperformance might lurk around the corner.
In conclusion, it’s imperative for investors to prioritize understanding and positioning themselves aptly in the face of volatility…or lack of it.
The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity. The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies. This is for information purposes and should not be construed as an investment recommendation. Past performance is no guarantee of future performance.