The Lesson Many of Your Clients Were Never TaughtAdvice to the Advisor
“That lesson has not customarily been taught in business schools,” Warren Buffett observes, referring to the concept that “Volatility is far from synonymous with risk.” In a 2015 letter to shareholders, the Berkshire Hathaway CEO wrote about the difference between risk and volatility. Many investors, he observes, “conflate these concepts, costing themselves money.”
Of course, the fact that stock prices will always be far more volatile than cash-equivalents must play a part in any advisor-client discussions of portfolio design. But, as Buffett emphasizes, over the long term, currency-denominated instruments are far riskier than widely diversified stock portfolios. He deplores the fact that in business schools, “volatility is almost universally used as a proxy for risk.”
So what IS the lesson about volatility and risk that deserves to be taught, according to Warren Buffett? “It is important to remember that the stock market does not exist to instruct investors; it is there to serve them,” Buffett teaches. “Put another way: Market volatility is a bad measure of investor risk.”
In a 2018 interview with CNBC, Buffett took the concept even further: “Volatility is a huge plus to real investors.”
So what about investment risk, then? There may be volatility, but you don’t run any real risk, Buffett says, assuming you:
- Understand the economics of the business in which you’re engaged
- Know the people with whom you’re doing business
- Know the price you’re paying for the investment is sensible
Sheaff Brock Institutional Director Jim Murphy agrees that understanding the difference between market volatility and market risk is a key skill for investors to have. Key to that understanding is realizing that while volatility demonstrates how rapidly or severely the price of an investment may change, risk describes the possibility that an investment will result in permanent loss of capital.
As an investment firm, Sheaff Brock’s “take” on volatility is that it offers opportunities to harness risk, rather than being synonymous with risk. As just one example, the objective of the Sheaff Brock Index Income Overlay portfolio strategy is to use options to take advantage of the difference that typically exists between the implied volatility and the actual volatility in the marketplace.
The message all investors deserve to hear is this: It’s a tragic, although classic, mistake to learn the “wrong lesson” from the market. You can put yourself at a disadvantage by equating risk and volatility rather than adopting strategies that may potentially profit from volatility.