An intelligent investor understands that stocks become more risky, not less, as their prices rise, and less risky, not more, as their prices fall. Risk is not the same as volatility as some people might appeal. There are many money managers who want you to suppose and convince others that volatility is equal to risk because volatility is a foremost risk for them since if stocks drop in price investors will abscond the money manager. These managers also adore equating risk with volatility since it gives investors the idea that risk can be accurately quantified which justifies their fees. Some probabilities are unidentified and some future states are unfamiliar, “risk” is not computable number. “Volatility” enables an investor to benefit from the market’s bi-polar behavior. In other words, volatility is actually the source of a value investor’s opportunity. In Berkshire Hathaway’s 2005 Chairman’s letter and annual report, Warren Buffett wrote,
I consider there to be three basic ideas, ideas that if they are really ground into your intellectual framework, I don’t see how you could help but do reasonably well in stocks. None of them are complicated. None of them take mathematical talent or anything of the sort. [Graham] said you should look at stocks as small pieces of the business. Look at [market] fluctuations as your friend rather than your enemy—profit from folly rather than participate in it. And in [the last chapter of The Intelligent Investor], he said the three most important words of investing: “margin of safety.” I think those ideas, 100 years from now, will still be regarded as the three cornerstones of sound investing.
There’s a lot of uncertainty in the market. Individual stocks have a tendency to have highly volatile prices, and the returns that an investor might receive on any single stock may vary wildly. Remember Warren Buffett’s famous dictum, “If they [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.” Price volatility is an inevitable aspect of investing in common stocks. Throughout periods when emotions are overlooking reason and logic, price volatility can become more noticeable than is normal during quieter times. In Berkshire Hathaway’s 1990 Chairman’s letter and annual report, Warren Buffett wrote,
[Many] investors who expect to be ongoing buyers of investments throughout their lifetimes … illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It’s the seller of food who doesn’t like declining prices.) Similarly, at the Buffalo News we would cheer lower prices for newsprint—even though it would mean marking down the value of the large inventory of newsprint we always keep on hand—because we know we are going to be perpetually buying the product.
Identical reasoning guides our thinking about Berkshire’s investments. We will be buying businesses—or small parts of businesses, called stocks—year in, year out as long as I live (and longer, if Berkshire’s directors attend the seances I have scheduled). Given these intentions, declining prices for businesses benefit us, and rising prices hurt us.
The most common cause of low prices is pessimism—some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.
None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: “Most men would rather die than think. Many do.”
Investors are susceptible to assess risk and build their portfolios based on the volatility of the market rather than the market—and more precisely their investments’—actual risks, even though an suitable dimension of risk in investing, especially for long-term investors, is the very reason for failure to realize a final outcome. In his seminal treatise on value investing, ‘The Intelligent Investor’, Warren Buffett’s mentor Benjamin Graham wrote,
Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.
Recommended Reading on Warren Buffett & Value Investing