The great investors and extreme volatility


Words of wisdom

Ben Graham wrote: “In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.” (Graham, The Intelligent Investor, 1973) p. 101.

Benjamin Graham was a British-born American investor, economist, and professor. He is widely known as the “father of value investing”. Warren Buffett was his student. Buffett credits Graham as his greatest influence.

There are two points here: firstly, whether he wrote that in 1949, at the time of the first edition of The Intelligent Investor, or in 1973 at the time of the fifth edition, it remains true today. Second, all investors should be well aware that a rise of 50% is the same as a drop of 33%. You have $100 dollars in stocks. Prices drop by 33%. Your paper worth is $66.66. It will take a 50% increase in stock prices to get back to $100.

For decades the most popular investing show on television was Louis Rukeyser’s Wall Street Week on Friday nights on PBS. John Templeton appeared frequently on the show.

Sir John Templeton was educated at Yale and Oxford and founded the Templeton Growth Fund in 1954. Templeton pioneered global diversification in the mutual fund industry. He was one of a tiny group of the greatest investors of the 20th century.

Templeton was the featured guest on the Friday following October 19, 1987 that saw the Dow Jones Industrial Average decline 22.6% on just that one day. This is a partial transcript of show:

“Louis Rukeyser: What is your advice to people in terms of the stock market now?

Sir John: Patience. Be a long-term investor. Be prepared financially and psychologically to live through a series of bull markets and bear markets because in the long run common stock will pay off enormously and the next bull market will carry prices far higher than this one.

Louis Rukeyser: Why?

Sir John: Because the whole nation is growing more rapidly. Gross national product of the nation will double at least in the next ten years. We think the gross national product of the nation forty years from now will be sixty-four times as high as it is now and that will be reflected in sales volumes and profits and share prices….” (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.222

John Templeton was able to quietly and confidently say that when the stock market had just suffered a 22.6% one day plunge!

Biggs recounts Keynes experience in the late 1930s. In mid-1937 Keynes suffered a heart attack. By the end of 1938 his personal capital had shrunk substantially and was down 62% from the end of 1936. At the time he was continuing to manage money for, or give investment advice to, several institutions. Biggs writes: “In 1938, with the bear market still in full force and even though still convalescing, Keynes found himself in the uncomfortable positions of having to justify his bias for equities to the investment committees of the institutions he advised and who had also suffered heavy losses. ‘I feel no shame at being found still owning shares when the bottom the market comes. I would go much further than that. I should think it is from time to time the duty of a serious investor to accept the depreciation of his holding with equanimity and without reproach himself.’” (Biggs, 2006)p.301.

The main downside to an equity weighted portfolio is that from time to time one’s investment assets may, on paper, shrink by in the order of 50%.

There are various strategies that can be adopted to somewhat mitigate this, but the truth is that one must be prepared for such volatility. Few are mentally equipped for such a roller-coaster ride. For those that have the stomach, the rewards can be substantial. It is worth noting that indexing does not remove volatility.

It is the philosophy espoused by the Motherlode that volatility, in itself, is neither bad nor good. It simply happens. Like rainy days, we simply have to prepare ourselves and put up with them. And like rainy days, if we are in the umbrella business, we can take advantage of them. Not all agree.

Volatility and risk

Since about 1952 it has generally been accepted in academia and the investment industry that volatility is a good proxy for risk. From that it is taken that if you want to measure risk you simply have to measure volatility. And, if you want to manage risk it is thought that you can do so through measuring volatility. The argument continues, you can control risk by controlling volatility. Also, it is said that while you cannot increase rewards i.e. returns without increasing risk, you can increase risk adjusted returns by diversification. And the way you measure risk adjusted returns is by measuring volatility. And the way you measure volatility is by calculating the standard deviation of your price data series.

Before we go too far with these thoughts, let’s see what Warren Buffett and some other investors have to say about volatility as a measure of risk.

Warren Buffett is reported to have written in the Outstanding Investor Digest August 8, 1997: “Finance departments teach that volatility equals risk. Now they want to measure risk. And they don’t know any other way, they don’t know how to do it, basically. So they say that volatility measures risk. I’ve often used the example of the Washington Post stock when we first bought it: In1973, it had gone down almost 50%, from a valuation of the whole company of close to say $180 or $175 million, down to maybe $80 million or $90 million. And because it happened very fast, the beta of the stock had actually increased. A professor would have told you that the stock of the company was more risky if you bought it for $80 million than if you bought it for $170 million, which is something that I’ve thought about ever since they told me that 25 years ago. And I still haven’t figured it out.”

This is a good place to point out that one doesn’t take advantage of volatility in the stock market by simply buying when the market takes a dip. A strategy of ‘buying on the dips’ is not a winning approach. Dips may allow an investor to buy with a margin of safety, but not necessarily. Simply buying on the dips is a market timing tactic that can lead to poor results. The intelligent investor will note that dips may provide the opportunity to buy a bargain at John Templeton’s time of maximum pessimism. The stock bought must meet all the investor’s standards for a superb company and the price must afford a margin of safety. The expression superb company is used in its ordinary English language meaning. The subject is explored in detail in the Motherlode Part 7: Building and Managing a Portfolio.

Lauren Templeton is John Templeton’s great niece. She is now a hedge fund manager. When she was twenty-four John Templeton seeded a hedge fund that she was to manage with $30 million. He set up very specific constraints as to what she could do and not do as manager. She says: “…so he set many investment parameters up in a way that made me stay the course and ride out any volatility. Volatility tends to unnerve investors, and he was not concerned with volatility. Basically, he was dismissive of discussions regarding standard deviation and similar measures. I believe he prized the market’s volatility because he saw it as creating bargains and opportunities, but this is not how most people think about the phenomenon.” (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.386.

When I read that Warren Buffett’s views contradict what is generally taught in finance schools and that John Templeton was dismissive of standard deviation and similar measures, it makes me think. These theories were developed by academics who won Nobel prizes. They have been accepted virtually as gospel by the vast bulk of the investment industry. As between Buffett, Templeton and Keynes, on the one hand, and the academic community on the other, I’ll go with the investment legends.

For readers wanting to dig deeper into this subject, take a look at Part 1: The Field of Play

In particular, Part 1 contains the following relevant chapters:

Chapter 4. Risk and Uncertainty

Chapter 7. Volatility

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

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