The Investment Scientist

Archive for April 2008

Confusing volatility and risk could cost you a bundle. Let’s take a look at returns on an investment of $1000 over 50 years from 1958-2007 in five asset classes.

  • Small cap value: $3,750,000
  • Small cap growth: $81,200
  • Large cap value: $854,000
  • Large cap growth: $130,000
  • CD: $13,800

Isn’t it obvious which is the best long-term investment?

Why small cap value is the best long-term investment

So you don’t have a 50-year investment horizon? Few of us do. How about a ten-year horizon? In any ten-year period from 1958 to 2007, small cap value had much better investment results than a “safe” CD. (See Table below. Green = best result in the given ten years; red = worst.)

Table: How would $1 investment become?

    10 year periods Small Cap Growth Small Cap Value Large Cap Growth Large Cap Value CD
    1958-1967 $5.64 $8.02 $3.22 $5.39 $1.36
    1968-1977 $0.97 $2.66 $1.2 $2.64 $1.75
    1978-1987 $3.38 $7.84 $3.52 $4.96 $2.41
    1988-1997 $2.87 $6.47 $5.38 $5.13 $1.7
    1998-2007 $1.53 $3.47 $1.77 $2.36 $1.42
    Annual volatility 28.23% 24.05% 17.67% 18.54% 1.7%

Safety paradox

Even though a FDIC guaranteed CD is perceived to be safe, over time, inflation eats away at returns. For the long-term investor – and by that we mean you – small cap value is less risky.

Why do few investors put their long-term investment in small cap value? And, when the going gets rough, why do many small-cap-value investors switch their money to CDs?

Here’s why, small cap value is highly volatile (See last row of Table) and volatility makes us anxious and jumbles our judgments.

Volatility does not measure risk.” -Warren Buffet

Volatility becomes risk only when the investor can’t stand it anymore, and abandons an otherwise safe long-term investment. Typically, volatility is highest and its impact most painful when the market reaches bottom. Not surprisingly, many investors bail out at the worst possible time.

Upon learning that he had to sail by the Sirens – the creatures whose beautiful songs could lure him to jump to his death – Odysseus asked his sailors to tie him to a mast. What mast do you tie yourself to?

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Portfolio review – uncover problems, avoid losses.

Volatility does not measure risk. The problem is that the people who have written and taught about risk do not know how to measure risk. Beta is nice because it is mathematical, it is easy to calculate and it is wrong – past volatility does not determine the risk of investing. In early 1980s, farmland that had gone for 2,000 an acre, went for $600 an acre. Beta shot up. I was apparently buying a riskier asset at $600 than at $2,000. Real estate not frequently traded. Stocks give you the ability to measure this volatility nonsense.

Because people who teach finance use the mathematics that they have learned, they translate volatility into all types of measures of risks — it’s nonsense. Risk comes from the nature of certain types of business, and from not knowing what you’re doing. If you understand the economics of the business that you’re engaged in and you trust the people you are partnering with, you’re not running significant risk.

Volatility as risk has been very useful for those who teach, never useful for us.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

Richard Conniff of MSN Money wrote about “How fear can make you loss millions.”

Blind trust in pundits could wipe you out as well. Alice Gomstyn of ABC News asked “Should you stay away from Jim Cramer?” (My answer is yes.)

Bob Klosterman explained life insurance in wealth management.

Greg Mankiw examined Barrack Obama’s tax return, he found Obama is not a fan of retirement saving.


Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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