Stocks

Risk Is Not Volatility, Risk Is Not Knowing What Causes Volatility

The conventional (Buy-and-Hold) view is that it is the volatility of stock prices that makes stocks a risky asset class. You know on the purchase date what your return is going to be on a certificate of deposit. So CDs are viewed as a low-risk asset class. But the value of your stock portfolio can go up by 30 percent or down by 30 percent over the course of a year. So stocks are risky.

long-term market timing
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This is just one more issue re which Robert Shiller’s “revolutionary” (Shiller’s word) research findings upends the old understanding of how stock investing works. If it is economic developments that cause stock price changes, as the Buy-and-Holders believe, then the investor can never know in which direction prices are headed (since economic developments are not known in advance). But Shiller showed that it is investor emotion (irrational exuberance or irrational depression) that causes stock prices changes. The investor can know in advance in which direction prices are headed because stock prices always head sharply downward starting from times of irrational exuberance and sharply upward starting from times of irrational depression. So long-term returns can be known, at least to a large extent. So where is the risk?

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Shiller does not deny that stock prices are volatile. But his research has changed the way in which the investor should cope with that volatility. If there is nothing that the investor can do to protect himself from stock price volatility, he has to accept it as a reality of the stock investing project and make the best of it (by being careful never to try to time the market). But, a price volatility that is highly predictable is not truly risky. If it a risk that can be avoided (by changing your stock allocation to bring your risk profile back to what it would be if stocks were priced reasonably).

Is a risk that can be avoided truly a risk? Not unless you choose to take it on. Driving drunk is a huge risk. But the dangers of drunk driving create no additional risk for drivers who remain sober (except that they can be hit by those who are not). Stock investors who take the added dangers of stock investing associated with high prices into account when setting their stock allocation do not subject themselves to volatility-related risk. They opt out of that risk of stock investing. 

Strangely, however, we cannot say that Shiller has in a practical sense done much to reduce stock investing risk. If stocks are more risky when stocks are priced high (which is what Shiller showed), there has never been a time in U.S. history when stocks have been more risky than than have become during the post-Shiller era (from 1981 forward). There have been two huge changes in the stock investing world in the past four decades. In an intellectual sense, most of the risk of the asset class has been eliminated. And in a real-world sense, stocks have become much more risky.

Risk is not price volatility. Risk is not being aware of the cause of price volatility. Investors who understood the implications of Shiller’s amazing research findings would obviously never follow a Buy-and-Hold strategy. They would aim to keep their risk profile roughly constant by adjusting their stock allocation in response to big shifts in valuations. But most of today’s investors take comfort in the high values that the market has temporarily assigned to their investment portfolios. They prefer feeling rich for a time to actually achieving a more permanent wealth.

This paradoxical choice points to the reality that makes Shiller’s breakthrough research so exciting. Buy-and-Hold posits that investors make rational choices. If that were so, there really would be no need for investors to time the market. The great irony is that Buy-and-Hold would work in a world in which investors knew to practice long-term market timing. The widespread practice of long-term timing would keep prices at reasonable levels and volatility would be greatly diminished from what it had been before Shiller published his research.

Most of today’s investors ignore Shiller’s Nobel-prize-winning research findings. We have collectively pushed stock prices (and, thus, volatility) to their highest levels in history. We have chosen to make stocks a more risky asset class. Because for most of us it has not clicked that it is the Get Rich Quick impulse that is at the core of the Buy-and-Hold disdain for long-term market timing (price discipline) that causes price volatility. 

All stock investors dislike price volatility. But how many have embraced long-term market timing, the only means of bringing price volatility down to acceptable levels? My guess is that it is about 10 percent of the population of stock investors who know to adjust their stock allocation in response to big price shifts. Imagine how much more rewarding stock investing will become for all when the popularity of Buy-and-Hold fades in response to the next price crash.

Rob’s bio is here.