Volatility in Your Portfolio Does NOT Equal Risk

November 20th, 2006

November 20, 2006 - Most financial consultants when they speak of your investment portfolio mention a low beta as a positive attribute. In fact, you will hear many wealth managers stress the need of having a beta close to 1.00. Beta, in simple terms, is the measure of a stock’s or portfolio’s volatility as compared to the volatility of the stock market index as a whole. So if you owned a stock with a beta of 1.30, it would be about 30% more volatile then the market index.

I’ve often seen the beta coefficient used interchangeably to define the risk inherent in a portfolio. For example, people will say if the beta of your portfolio is much greater than 1.00 then you have an aggressive, risky portfolio and if the beta of your portfolio is much less than 1.00 then you have a conservative portfolio. This is nonsense.

First of all, the beta coefficient is determined using the domestic stock market index as the constant. For example in the U.S., the beta coefficient will be determined by comparing the volatility of a stock or stock portfolio versus the volatility of the S&P 500 index. But we are already starting off on the wrong foot by doing so because nobody should have a stock portfolio that is concentrated in their domestic market only. Chances are that many of the best performing stocks you will own will be in a foreign stock market. So what if the beta of your stock portfolio is high compared to your domestic market index but low compared to regional market index? What does that mean?

Or what if the situation is reversed. Your portfolio has a low beta compared to your domestic market index but a high beta compared to a regional market index? This could happen if your domestic market is particularly volatile one year while the rest of the world markets are significantly less so. If your domestic market index is up 35% one year and your portfolio is up 33% the same year, because your beta is less than 1.00, does that still mean that you have a conservative, low-risk portfolio?

Investment firms will almost always tell you a high beta is bad, and that to have higher volatility is a great risk to your portfolio. If you live somewhere where the stock market index has returned on average 3% for the last five years and has moved within a very narrow range, I would say that to have a low beta is extremely risky because that means that your portfolio is going nowhere, and that if you add in the effects of inflation, your flat portfolio has lost purchasing power over those three years. On the other hand, if your portfolio has returned 20% on average over this same time span, your beta will be off the charts. But isn’t a high beta bad? Not at all. If this is the case, then I want my beta to be high, and I want the volatility of my portfolio to be much higher than the domestic stock market index.

Volatility is not the same as risk. Personally I want volatility in many of the stocks I own. If a stock is to return 50% to me in one year, by nature it has to be fairly volatile, because almost no stock just rises steadily higher without experiencing some significant corrective actions to the downside. Therefore, stocks with significant gains are going to experience wider fluctuations in their value. It simple is not possible to build wealth without having some huge winners in your portfolio – stocks that have appreciated by 70%, 150%, 350% or even a 1000%. According to the theories propagated by most investment firms, almost all people that have built substantial wealth through their stock portfolios would have engaged in highly risky behavior.

Again, this is just not true. Investors that have huge winners in their portfolios make calculated intelligent decisions to identify asset classes that are poised to boom before the public considers them. They invest at troughs in price and sell when mania sets in, allowing them these huge gains, whereas the average investor will only identify these stocks after everyone else becomes aware of them or some talking head on TV marks it as a screaming buy. Thus, the average investor will only earn average money from this stock or quite possibly lose money if he or she purchases at the mania phase, while the wealthy investor will have earned phenomenal returns.

If you ask most people, they could care less if they had four stocks that lost 40%, 50%, 45% and 55%, if they also owned eight stocks that rose 80%, 100%, 130%, 300%, 287%, 200%, 184%, 65%, and 658%, and their overall return, given the average performance of their remaining portfolio, was 55%. At the end of the day, people only care about the total return of their portfolio. Investment firms have always stated that such a strategy as risky. If you have stocks that have performed that well, you must be taking huge risks, right? Again this is nonsense.

Uncovering volatile stocks that will prove to be huge winners requires time, a commodity that financial consultants do not have as they run their race to gather as many assets as possible. Again, earning these gains is possible without assuming much risk if you perform your due diligence and discover solid assets at rock-bottom prices and invest in them before the general public discovers them. In fact, I would even argue that some stocks that earn 150% or more are less risky than the market stock index at the time I identify them. Why? Because prior to their 150% run up, they were extremely solid companies at extremely cheap prices.

Just as I have spoken about dumb diversification versus smart diversification, there is the assumption of dumb volatility versus the assumption of smart volatility. Dumb volatility is chasing penny stocks and pipe dreams of quick returns from companies that spend more money on marketing and PR campaigns to promote their stock than on the operations of the company itself. I have already described above how to add smart volatility to your portfolio. Of course building an entire portfolio comprised of volatile stocks would just not be intelligent either. But building a portfion of your portfolio with such stocks to boost returns is smart.

Volatility is not the same as risk as much as most global investment firms want you to believe this. Again, read my previous blog entry if you’re still not clear as to why this is the case. Low volatility, high diversification, and mediocre returns are a time minimization/ asset gathering maximization sales strategies. Volatility is your friend when building wealth.

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J.S. Kim is the founder and Managing Director of SmartKnowledgeU™, a comprehensive online investment course that uses novel, proprietary advanced wealth planning techniques and the long tail of investing to identify low-risk, high-reward investment opportunities that seek to yield 25% or greater annual returns.

Entry Filed under: Wealth Literacy