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Finance > Investing > Volatility Is Your Friend
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Article rating : 0.00, 0 votes. Author : Hari Wibowo
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.
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