- Risk comes from uncertainty, which can be about an asset's valuation or future events.
- In the same way price follows value, volatility follows risk.
- Margin of safety is always important, but even more so when investments are risky.
Defining risk is hard, and not that useful. Most investors already have some intuition about what constitutes risk, and it's not an easy area in which to change people's minds. If we adopt Warren Buffett's model where every asset has an intrinsic value determined by the expected future cash flows the asset will generate, there are essentially two sources of risk. One is that if circumstances change the expected future cash flows (and thus the asset's intrinsic value) might change along with them. The other is that calculating intrinsic value is not a science and we might make a mistake.
Thus, an asset's level is risk is determined by how likely the asset's value is to change and how difficult the asset is to value. As these factors play out in the market, a risky asset is in general going to exhibit larger price changes than a less risky asset. It may not happen overnight. But eventually, it will. Price follows value in the long run. If the value is prone to change quickly, the price will be too.
Start watching asset prices, and the relationship becomes pretty clear. Options are more likely to change in value than stocks, which are in turn more likely to change in value than bonds. Sure enough, option prices show greater volatility than stock prices, which in turn are more volatile than bond prices. High-growth companies with no profits are harder to value than stable companies with consistent earnings, and guess which group shows more price volatility? That's right - the riskier one. Like the rule about price and value, the risk/volatility rule is temporarily violated from time to time, but in the long run, volatility follows risk.
The dilemma is that while changes in value will eventually be reflected in the price, not every change in price reflects a change in value. And when we observe a large change in price, we are often left to wonder: Was the change just noise, or did something happen that has caused the value of the asset to change? If it was the latter, was the price change too big, or not big enough? In the moment, we can't tell.
And this is where I don't agree with Buffett. He has argued - using the price of the Washington Post, supposedly during a speech at Stanford Law School - that if volatility is the same as risk, then an asset whose price has dropped sharply has become riskier. In reality, though (he argues) the asset has become safer, since you are paying less for the same asset - potential losses have diminished, and potential gains have increased. His logic is correct - in a world where you can value the asset with 100% certainty. In the world most of us live in, however, there's more to the story. If the price of an asset we thought was fairly priced drops by 50% and we don't see why, it's entirely possible the value of the asset has dropped 50% and everyone in the market has figured that out except us. That might not be the case, and we hope it isn't, but most people in this scenario would take another look at their valuation of the asset to see if maybe they missed something.
Volatility doesn't cause risk; it reveals it - albeit often with a great deal of noise embedded. This doesn't mean volatile investments are a bad plan, but it does mean that if the investment is volatile, the margin of safety had better be screamingly large, which it usually is not. If the investment is less volatile, a margin of safety is still a good thing, but does not need to be so big.