The Investment Scientist

Posts Tagged ‘volatility

Over the last 60 years, the simple average annual return of the Fama/French benchmark small-cap portfolio* was 16.3%. For the same period, the large-cap portfolio* was only 12.76%. Do you think small cap beat large cap by a wide margin? I put my mathematician’s hat on to find out.

Volatility shrinks the return difference

The small-cap portfolio return volatility for this period was 26%, and 16.4% for the large cap. Taking into account the drag to return by volatility , I calculated the geometric mean return for both portfolios. My results showed 12.9% for small cap, and 11.4% for large cap. Mathematically, the return advantage of the small-cap portfolio is significantly reduced by its volatility.

The odd favors small cap … somewhat

For most investors, long-term investing means holding a stock for three to five years. What is the odds of the small-cap portfolio beating the large-cap portfolio? Not by much.

In any given three-year period during the last 60 years, the odd of the small-cap portfolio beating the large-cap portfolio were only 51%. It increases to 58% when the investment horizon is 5 years and 72% when the investment horizon is 10 years. For most investors, the odds barely favor small-cap investing.

Investment horizon 1 year 3 years 5 years 10 years 20 years 30 years
Odds of small cap beating large cap 53% 51% 58% 72% 75% 90%

Data source: Kenneth French data library

Emotional accounting

Daniel Kahneman, the 2002 Economic Nobel laureate and the father of behavioral finance observed that the pain from a loss is twice the pleasure from a gain of the same size.

Applying his principle: I assigned one unit of positive emotion to each 1% gain and deducted two units of positive emotion to each 1% loss. So a resulted positive number represents pleasure and a negative number represents pain. The sum of monthly results over the last 60 years showed: -788 for the small-cap portfolio and -482 for the large-cap portfolio. It is clearly painful to invest in stocks, small cap stocks especially. (This also explains why people prefer to put their money in CDs.) Is the pain of small cap investing worth the gain? You decide.

There are ways to reduce the pain and enhance the gain through diversification and valuations. They are the subjects of my future newsletter, which you can subscribe here.

*Fama/French benchmark small cap portfolio contains stocks in the bottom 30% of market capitalization. Fama/French benchmark large cap portfolio contains stocks in the top 30% of market capitalization.

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.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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