Volatility does not mean risk

In chemistry, ‘volatility’ refers to the ability of a substance to evaporate quickly—or, under the right conditions, to explode. In investments, it means much the same thing. Still, we don’t think you should avoid volatility altogether. So what’s the difference between risk and volatility?

Stock markets worldwide have shown exceptionally high volatility since the autumn of 2008. In Canada, the S&P/TSX Composite index lost about half its value in ten months—from a peak in May, 2008 to the bottom in March, 2009. Since then, stocks have rebounded. Even so, Canada’s stock market remains volatile, as investors react to both positive and negative surprises. Earlier this year the market faced another bout of volatility.

Volatile investments appeal to some investors, because they see volatility as their source of profit—what can go down far and fast can also rise that way. You might say these investors confuse volatility with risk. But the two differ.

Risk has to do with the strengths and weaknesses of a company you own—whether it will prosper or go broke. Volatility has more to do with the way share prices behave. For instance, a promotional stock with few assets and no profits may display low volatility for long periods when the promoter is in control of the market. But it still exposes you to great risk.

Volatility and share price behavior

On the other hand, high-quality stocks can be volatile because of such factors as, say, fast-changing regulatory or business developments. Consider BCE Inc. Over many years, the company’s stock has become more volatile with de-regulation, rapid technological change and more competitors.

But thanks to its high investment quality—its substantial assets, solid business base, earnings, dividends and so on—it still exposes you to relatively less risk of a big long-term loss.

It’s also easy but mistaken to see volatility as the key difference between aggressive and defensive investments. Aggressive investments do tend to be more volatile, of course. But these two kinds of investments lie at either end of a continuum, and volatility is just one of many factors that vary between the two ends of that continuum. Other factors that can change from one end of the continuum to the other are the degree of stability in the business, length of the dividend history, hidden assets on the balance sheet and so on.

Volatility is a relative term—it always involves comparison. Over the years, analysts have tried to quantify volatility. The best-known measure of volatility is the ‘beta co-efficient’. If a stock moves in line with the market (or some part of it), it has a beta of 1.0. A beta above 1.0 means greater volatility than the market or sub-sector. A beta below 1.0 means less volatility, of course.

Lots of factors may raise or lower the volatility of a stock. Few would surprise you. Volatility depends partly on the type of business a company is in. Companies in the manufacturing and resource sectors generally have stocks with above-average volatility. Companies in the utility and financial sectors have historically shown greater price stability. Consumer stocks are generally about average.

Regardless of sector, the shares of a company that is undergoing a restructuring are almost certain to be more volatile than those of a business in a settled phase of operation. High overhead, heavy capital spending, large debt and changes in the market can also expand a stock’s volatility.

Thin traders are usually more volatile stocks

Thin trading shares are generally more volatile than liquid, active stocks, because it takes a smaller buy or sell order to move prices. For the same reason, low-priced stocks are often more volatile too. They also attract traders.

If you invest in volatile stocks, you should monitor your selections more carefully than you would with ones that are more stable. With a volatile stock, matters can deteriorate quickly.

Some investors buy a portfolio of stable stocks, and then pay sporadic attention to their investment performance. But it’s by no means unknown for a respectable, placid stock to suffer an upset.

Keep in mind that a volatile stock is usually volatile for one key reason: nobody knows what it really is or should be worth. To put it another way, nobody knows how things will turn out for it. But they do think the outcome could differ drastically from the current situation.

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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