Volatility Is Your Friend
A lot of investors dislike volatility. They reason that the up
and down movement of the stock price makes it harder to predict.
Higher uncertainty means higher risk, they say. Therefore, for
the same reward, they prefer stocksthat has a lower volatility.
On the contrary, smart investors like Warren Buffett embraces
volatility. He reasoned that if a stock A is trading at $ 50 and
has a fair value of $ 60. Shouldn't A be less risky if it
plunges to say $ 20 or $ 15? That is a valid point. This of
course assume that the fundamental that caused the drop has not
changed.
I like volatility for several reasons. For entry and exit
points, volatility increases our potential return. No, I do not
advocate day trading. No, I do not recommend buying stock A at $
30 and selling it at $ 31 just because it has risen in value. We
should try to be investors with long term horizon of at least
one year.
Another reason to like volatility is that it reduces
uncertainty. Some of you might roll your eyes and think that
this is nonsense. Let us explore this. What causes a stock to
move? The stock price might move due to market sentiment. It
also move when it release earnings or new products or news about
incoming threat from competitors. In other word, the stock price
moves due to the news concerning the company.
News are fact. Fact are certainty. Therefore, when the news is
out, you get less uncertainty because the unknown has already
been discovered. Be it bad or good, news always reduce
uncertainty.
For example, when Merck & Co Inc. (MRK) announced the withdrawal
of its painkiller drug, Vioxx, that reduces uncertainty. Sure,
shareholders lost money as the stock price plunged and
volatility increased. But, sooner or later, Vioxx will be pulled
anyway. Not pulling Vioxx only make the liabilities worse. Now,
potential investors can estimate Merck's fair value based on the
'bad' news. While the news is bad, it reduces uncertainty which
reduces risk. This is in a sense good news for investors.
It is hard to fathom. But we need to embrace volatility. Sooner
or later, a company will announce news, which can be good or
bad. Either way, the stock price will be volatile when the news
is announced. Volatility is bound to happen. Otherwise, how can
we investors profit from it? When a company's stock price does
not move much, you can't profit much and vice versa. The trick
is knowing when to buy and when to sell. That will determine
your rate of return.