Dec 112012

One myth about investing in the stock market or any other market where prices fluctuate is that it’s risky. But people who know how to value a stock understand that it doesn’t have to be risky if they buy the right stocks at the right time. Volatility and risk aren’t always correlated. Some companies with steady growth such as Enbridge have been pretty stable over the years.

Enbridge stock chart, volatility and risk

That’s not to say ENB is a good buy today because whether a stock is reasonably valued or not is another topic. But here’s a look now at Caterpillar below, who manufactures construction equipment, heavy machinery, etc.. Notice how the stock is more volatile over the same period as Enbridge.

Caterpillar stock chart, Volatility and Risk

But that doesn’t necessarily mean CAT is a riskier stock than ENB.  CAT is a more cyclical company so its Beta is suppose to be higher. What makes a company safe to invest in for myself is a positive trend of earnings growth, dividend growth, and industry expansion. Both companies have had stable dividend growth over the last decade meaning managers are confident about their company’s future performance. Both companies have also increased their profits over the years. Pipeline companies are looking to expand their pipes across Canada, and In Alberta alone the government has forecast there will be 114,000 jobs in the construction industry over the next decade (o.O) ENB and CAT are both in growing industries with growing demand for their products/services.  Stocks can vary in risk depending on what kind of business they are, but volatility doesn’t necessarily mean risk. It just means at some point in time, there might be  a good opportunity to buy the stock at a great value 😉

Here’s what the Oracle had to say on the subject….

“Volatility does not measure risk. Past volatility is not a measure of risk. It’s nice math, but it’s wrong. If a farm in Nebraska used to sell for $2,000 per acre, and now it sells for $600 per acre, investment theory would say that the beta of farms has gone up, and than they are more risky than before. If you tell that to people, they’ll say that that’s crazy. But farms don’t trade daily the way stocks do. Since stock prices jiggle around, finance professors have translated that into these investment theories. It can be risky to be in some businesses. Risk is not knowing what you’re doing. If you know who you’re dealing with, and know the price you should pay, then you’re not dealing with a lot of risk. We have invested in a lot of sectors that have high betas. The development of beta has been useful to people who want careers in teaching.”
– Warren Buffett

Beta – The measure of volatility. Higher beta = bigger fluctuations in price. The overall market has a Beta of 1. If a stock is said to have a Beta of 1.5 then that means it will be 50% more volatile than the market.

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21 Comments on "Volatility and Risk"

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John S @ Frugal Rules
12/11/2012 9:30 am

Very good description of the difference between the two. I love being able to snap up a good opportunity because it’s volatility has caused it to dip and thus making it an enticing buy.

TB at BLueCollarWorkman
12/11/2012 11:55 am

I never really thought about a point you mention right up top, which is, some stocks are pretty steady and just go up slowly (generally), while others are more cyclical. I never really knew that or thought about it. But reality is, if you can look ata company’s history and know which it’s doing, then there’s not much risk there, I think.

12/11/2012 3:36 pm

Beta generally uses an overall market index as a benchmark such as S&P500 or FTSE but IMHO you have to be careful with this. If you are using it for decisions as to which asset to buy/sell and are working only within one sector, I think it is better to choose a specific benchmark rather than a general one. Although this will make the computation rather messier….:-)

12/11/2012 9:29 pm

That’s a good explanation. I definitely don’t examine stocks as much as I probably should, which is one of the reasons I stick with funds. :p

12/12/2012 5:12 am

The higher the beta, the more connected to the company you must be to capitalize on timing the buy and sell. Cyclical stocks have great potential for rewarding those that spend the time watching them. As John above points out, it is but one indicator though. As you and many others on this blog know, investing is a complex game of ifs, what ifs, gut feels,etc… but if you watch and listen to enough of the noise out there, some of it starts to make sense over time – at least we may perceive it to anyways ^_^ . Bottom line is there are reasons things can seemingly, consistently work for some…I spend my energy trying to follow the flow of the money, into the company, out of the company, and hopefully into my pocket.

12/12/2012 5:29 am

Thanks for sharing this information as I’m reading as much as I can to learn about stocks and investing. It’s alot of work and like the poster above says it is a complex game. Mr.CBB

Jordann @ My Alternate Life
12/13/2012 6:14 am

Interesting! I just learned something new.

Alex Yang (@yyangalex)
12/15/2012 9:15 am

nice post. its such a hard point to explain to average joes that the primary factor to risk is actually valuation, not volatility. you’re MUCH more likely to lose money by buying something that is overvalued than you are buying something that is volatile.

Johnny ca$h
12/19/2012 5:39 pm

Good Post Liquid!

04/15/2016 9:33 pm

[…] Independence has covered volatility and risk in the past. The article comes to the same conclusion – stock price movement is not real risk.  […]