You Need to Know About Volatility

Paul Winkler: And a welcome to “The Investor Coaching Show.” Paul Winkler.

So I was having a conversation with somebody who didn’t really know what we did.

I love those conversations. They have no idea what we do, and what I do, and what I’ve done for 20 years on this show.

He was like, “I love it. It’s, like, the little guy against the establishment.”

I’m like, “Yeah, that’s pretty much it. David and Goliath is kind of the way we look at it.”

And I like explaining what is the academic research of the past 70—yeah, about 70 years plus. It is 70 years. Good grief.

And some of it, I mean, there’s been a great evolution over the years, as far as new information coming out and building on existing information.

Back in the 1950s, it was, how do you put things together that has the ability to reduce the risk of a portfolio? So we can decrease potentially—you always say “potentially decrease” because you just never know what’s going to happen.

You can have thermonuclear war and everything doesn’t work anymore. So I try to be very careful to always say potentially, potentially, potentially.

How Correlation Impacts Diversification

But if we look at what, historically, can reduce the risk of a portfolio, one of the things we always talk about is diversification. Now, why and how?

Well, when we have correlations between two things, if two things always move together, then one of them isn’t needed. And if we look at investment markets, there are going to be very dissimilar price movements over long periods of time.

Now you can go short periods of time, and you can look at short periods of time and go, “Diversification’s dead.”

I mean, that’s basically what happened in 2008—right? and early 2009—is people came out of the woodwork and said, “Diversification is dead; it doesn’t work anymore!” inside the industry, which made me just shake my head and go, “No, wait a minute, guys.”

And it bears my repeating what happened because this is something you will find from time to time. You will find that things do move often together at the same time.

You’ll find that they go down together or they go up together. But if you watch really closely, they don’t move to the same degree.

You might have something that goes down 1% and the other thing goes down a half a percent, for example. Well, that may not seem like a big deal over the course of one day, but you know, it is a big difference over time if one thing is less volatile, let’s say, or when something goes up.

One thing may go up 5% and the other one goes up 3%.

I mean, short run, doesn’t seem like a big deal; long run, it’s a huge deal. It’s the difference between 2%.

I mean, good grief, if you look at large U.S. stocks, a dollar grows to $10,000 from 1926 till now versus over $30,000 for small U.S. companies. So you look at the difference and go, “Whoa, that’s a pretty big difference!”

Well, it’s only 2%, so it doesn’t seem like that big of a difference.

But you’ll have periods of time when things seem to move together and maybe to similar amounts. Like 2008 was an example.

You’ll have—a lot of asset categories went down about 40%. And some went down even greater: 60%.

The Market Always Recovers

And one of the things that I pointed out back at that point in time—because it was like the world was ending back then. I mean, people were just despondent about stock markets.

And I said, “Hey, you got fixed-income investments”.

If you had fixed-income investments, they went up over 10%. Now that’s not as much as stocks went down, but that gives you something you can draw income from to buy you time from when markets recover.

Because they always recover. Always recover. Why?

Because people run the companies, and they do whatever they’ve got to do to increase profitability, which may mean cutting the expenses to the bone. But eventually they’re going to do whatever they’ve got to do.

That’s why I don’t worry about stock market downturns.

One of the things I said back then was this. I said, ”Hey, look. Think about this. Let’s say that you went to a party, and you had no clue about any of the people there.”

You didn’t know who to trust. You didn’t know a single soul.

You might be the type of person that says, “I’m not going to that kind of a party. I would never show up in a place that nobody knows me or I don’t know anybody because that’s not comfortable.”

Be it as it may, let’s say that you ended up in that situation. And you just ended up in this place, and you’re walking around, and you’re trying to talk to people, and you’re trying to figure out, who do I trust here?

Well, that’s kind of like the stock market. You go into unknown territory with markets, and new information comes out.

You might have every area of the market go down a similar amount in a short period of time. And it may go up a certain amount over a short period of time as well.

I mean, this isn’t just down, but typically the reason I talk about down is because that’s what everybody worries about, right?

Nobody worries about upside volatility. It’s always downside volatility that wigs people out.

So if you’re looking at that scenario where new information comes out, and you look at the markets and go, “Wait a minute, everything’s kind of moving together, what’s going on here?”

Well, that’s not unusual because new information kind of freaks everybody out. So everybody goes, “I’m scared! I want to get rid of this.”

And people that are willing to buy—because there’s always somebody on the other side of the trade.

There’s always someone on the other side of the trade who goes, “Hey, you know what? You’re willing to sell. I’ll tell you what, I’ll take that stuff off your hands.”

Because they know, kind of like I do, that markets have always recovered, and because it’s run by people who will do whatever they’ve got to do to get their stock prices to go back up.

Ups and Downs in the Market Are Normal

And the reality of it is, that’s why we look back through history, and it looks like you’re walking up and down the stairs with a yo-yo when you look at stock market charts.

It’s up, down, up, down, and up, but the general trend is up. So it’s a gradual slope moving from left to right, going up.

And they’ll take it off your hands. “No problem. I’ll take this, and I’ll profit from when it comes back.”

And that’s why, so often, what happens is you’ve got these market downturns, and they’re just a great opportunity to transfer money from people that don’t have the guts or the intestinal fortitude to put up with it to people that do have that.

So what happens is, with these transfers, you’re basically having somebody else buy that thing off of you, and they end up profiting from that.

Well, when you have these downturns, nobody really knows what’s going on. They don’t really, really know.

So you’ll have a lot of people that just sell across the board and that’s it, so everything may go down a like amount.

But—like being at that party where you don’t know anybody, you don’t know who to trust—as time goes on, you start to figure out who you can trust, who you can talk to, who seems to have a decent personality that you can hang with. And you spend more and more time with that person, right?

Diversifying Protects Investors

Let’s think about the stock market this way. As new information comes out, and as the picture becomes clearer—what’s really going on in the economy—then the companies that are going to benefit from the new circumstances, they’re going to go up in value more than everything else, and they’ll recover.

And that’s exactly what happens during market recoveries. You’ll find that certain areas will recover better than others.

For example, you had the tech bubble, when that whole thing went down. Tech stocks—three years, you literally had tech stocks dropping, like, 80%.

And people would call the radio show and go, “Oh, what do I do?”

And I’d go, “Well, you know the thing that got you in trouble?”

“Yeah.”

“Is that usually the thing that gets you out of trouble?”

And they would go, “No, that doesn’t make any sense.”

And I’d say, “Well, good. I’m glad to hear you don’t think that makes any sense because it doesn’t make any sense to me. So when’s the best time to be prudent?”

And they go, “Well, I guess whenever you figure out what prudent is.”

And I say, “Okay, good. Do you think that diversifying is prudent?”

And they go, “Well, yeah, that seems like a pretty good idea.”

And I would say, “Okay, so you know that diversifying is prudent. You’re not diversified.

“You weren’t diversified. So maybe being prudent right now, when you know what prudent is, is a good idea.”

And they go, “Oh, okay. But you mean, I got to sell this thing? It’s low. Can I just do it when it bounces back?”

And I will go, “The thing that got you into trouble isn’t the most likely thing to get you out of trouble.”

And … “Okay, no.”

And just kicking and screaming, you might be able to get the person to do the right thing. It’s never easy, I’m telling you.

So what happens, though, and what did happen back then, was international small companies, they were rocketing up over the next several years. I mean, it’s just not an area of the market you would have even taken a second look at because it literally had a five-year return from 1995 through, like, 1999 of no return, zero, zip.

So it was on nobody’s radar screen. But it was something that, from an academic standpoint, it made sense to hold it, not because it was low and it was getting ready to rocket up. Nobody was on the radar.

It was just, “Hey, you know what? These companies got to pay to use your money as well.”

And yeah, they haven’t done much of anything for five years. But good grief, large U.S. stocks, who still have to pay to use your money, by the way, went for, like, 12 years with no return.

So why would we think other areas can get away scot-free without having to pay anything to use your money? That doesn’t make any sense.

So when the recovery occurred, we didn’t know what area of the market was going to benefit from that, and it’s kind of nice if you own some of those things.

Research and Measurement Can Help Drive Down Risk

So hence, what happens with diversification is you can measure. This goes back to the 1950s, like I said.

And what I do is I know how to measure the correlations of various things, and I can put a portfolio together with lower correlation to drive down the risk of the portfolio. So that’s one piece of academic evidence.

Another one is market efficiency and the idea that, hey, you’re not going to find mispricings in stock markets reliably.

And how do we know that? Well, professional managers don’t seem to be able to do it.

And because they don’t seem to be able to do it, the layperson’s probably not going to be able to do it either.

And how do we know that they can’t do it? Well, because it’s like over 90% of them over 15 years—depending on the asset category, it could be almost 97–98% of them—fail to match market returns.

So most people think, Okay, so here’s what we do is let’s just index the portfolio.

And I go, “Ohhh, not quite.”

Because indexing the portfolio works with two asset categories, large U.S. and large international. It doesn’t work very well for small companies. Why? Because they overweight big companies.

And what are we trying to do is we’re trying to own small companies, so that kind of messes that up.

And then it doesn’t work very well for value, because what are we trying to do? We’re trying to buy companies that have a low price compared to their book value.

And because of the way index funds weight bigger companies, they’re going to be overweighting the higher-price companies compared to book value.

So by definition, it just doesn’t work that well in most of the asset categories that it would help. But it does work better than active management, and hence, the marketing drives people toward that.

Defining Value Funds

Now, so what do you do? Well, I typically look for funds that are actually capturing factors, and they’re not necessarily worried about cap waiting in the portfolio.

So what’s that? Well, I look for a value fund.

I’m looking for a value fund: a fund that is investing in companies that have a price that is fairly low compared to book value and in the bottom 20% of all companies when it comes to price-to-book, and then subtracting some things like profitability factor and just things that are way too complicated for the show.

But it’s important that you know that that is the criteria, that there is criteria to determine what value is.

And typically, people don’t even realize it. They see a value fund, and they go, “Well, that says value, and what do they mean by value?”

You almost have to play stupid and say, “What do they mean by value?”

And go, “Well, it’s undervalued.”

Uh-oh, no, that’s not the right definition.

Or “It is in the bottom 50% of the market.”

Or “It’s measured by price-to-book and price-to-earnings and price-to-sales, what price the companies are selling for compared to their earnings.”

Well, that’s not the best measure. Why is that not the best measure?

The Pitfalls of Price-to-Earnings

Well, price-to-earnings, you may hear it. It gets a lot of press; it really does.

And the reason is it’s just something easy to look at. And you hear a lot of people talk about price-to-earnings.

But the problem is that companies might have a good quarter of earnings, and then they’ll have a bad quarter of earnings.

And then they might have great earnings for six months or something like that, and all of a sudden, their earnings are high compared to the price now.

So it’s price-to-earnings. And what happens is, all of a sudden, their earnings are high compared to price, and then that makes it look like a value company.

Well, it may be just one good quarter. So you see how complicated this can be?

If I have a number—I’m going to use an example.

So let’s say that I see a company that has a price of $20 for every $1 of earnings, so it’s a 20-1 ratio. Well, that would be more of a growth-oriented company at that particular ratio.

Now what if they have a really good earnings quarter, maybe some expenses went down or whatever, and now they had $2 in earnings and the price was still $20, okay? Because we expected that it was going to have that good earnings quarter, so it didn’t affect the price any.

So let’s say that happened. Now, it’s 20-to-2, which is a what? 10-1 ratio now. 20 to two is as 10 is to one.

And now I’ve got a situation where I’ve got a company that, whoa, this looks like a value company, but it’s not.

It just had a good short-term period of time when it had good earnings, and therefore, now it just looks like it’s value, but it’s not really value.

And I hope this makes sense. So what happens is it’s not a stable denominator that earnings can fluctuate quite a bit.

So hence, when Gene Fama, the University of Chicago guy that won the Nobel Prize for 2013, when he did this research, he basically said, “It’s not the greatest thing, price-to-book.”

That’s what I used in my research. And I looked at—

Bottom 30% is what he looked at when he did his research. Now bottom 20% is typically what you’ll find when companies are doing that.

The Science of Investing

And you just got to know what to look for when you’re owning funds. And it may change from time to time.

You may look at a fund and, all of a sudden, it develops a capacity problem.

In English, what that means is funds get too big. And when they get too big, literally every time they trade stocks, they literally trade against themselves.

So sometimes you make changes in the funds. Not very often, but once in a while, you’ll make changes based on that the fund gets too large or there’s a lower-cost alternative out there or something like that.

Most of these are all things that we look at. So typically, what I tell people, our clients, is, “Look, don’t expect to know everything I know.”

I just want you to recognize that there is science behind investing. And once you get that, you worry about it less.

You understand that you’re not just throwing your brain away when you invest. And that, to me, is key, because investing is going to be a difficult process for anybody.

Why? Because it’s so different from anything else that we do.

When I do something, when I go and I buy a car, I expect that every time I get in it—almost every time I get in it, most of the times that I get in it—it will start.

I expect that when I go use my dryer at my house that most of the time when I push the buttons, the right button anyway, that the dryer will come on.

I expect that when I turn my stereo on and listen to the radio, it’s going to come on.

Markets, they go up and they go down. Sometimes it seems like it’s broken because it goes down. And you just realize that comes with the territory.

And when I understand what am I doing, why am I doing, what can I expect from this process—I understand these things—then I can put up with, “It doesn’t do what I expected it to do.”

Well, let me take away, because if I expect that it’s going to go down, I’m okay with that.

But it doesn’t always go up. Let me just say that.

If it doesn’t always go up, I’m okay with that because I am pretty confident. Because I know what I did and how I put the portfolio together and why I put it together the way I did, enough that I don’t worry about that I made a bad decision.

Because let’s face it, as I always say to people, “You know what? You will never second guess yourself when the market’s going up.”

It’s always when it goes down that you go, “Did I make the right decision? Is this the best thing?” And you’ll second guess yourself at those points.

That’s why the education is so important. That’s why I continue to teach as much as I do.

And maybe just teach you a little bit of new stuff every time, so at some point you go, “I got this. This makes sense.”

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