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Volatility Is Not Risk

 April 12, 2012 12:17 PM


This article was inspired by Roger Nusbaum's post on his Random Roger blog – Sunday Morning Coffee on Sunday, April 8, 2012.  Roger is a highly respected financial blogger that I believe is genuinely interested in providing his readers meaningful and prudent investment advice and guidance.  Therefore, I have a great deal of respect for his work and intentions. On the other hand, Roger and I often disagree on certain investing principles, especially those that deal with asset allocation, proper diversification and the definition of risk.  However, I would hope that he respects my differing views as being offered with the same best of intentions, as I see his offerings.

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The Greater Risk is People's Reaction to Volatility

Roger's blog dealt with his feelings about a recurring theme in Barron's over the weekend referencing people's complacency for risk. The first part of his writing dealt with the risks associated with the utilization of puts.  On this subject, Roger and I are in agreement.  However, the second part of his blog talked about what he obviously felt was the great risk of using dividend paying equities as an alternative investment choice.  The following excerpt introduces his views, which frankly, up to this point, I take little exception to:

"The other point from Barron's (this was repeated in a couple of places) was a repeat of the idea that the Fed's interest rate policy (and the other attempts to stimulate the economy) are forcing investors into other instruments to seek a "reasonable return."

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However, I do take exception to his next paragraph as I felt that it is overstating the risk associated with the utilization of dividend paying stocks for two primary reasons.  First of all, his assumption that a bear market will provide a tragic outcome because dismayed investors will panic is more assumption than fact. Second, his last sentence insinuates, at least in my opinion, that dividend paying stocks are not safe investments.

"I hate this line of thinking. It would be great to get a "reasonable" rate of return from cash and treasuries but for now that is not the case. That people put what should be their low risk dollars into higher risk instruments to get a return they used to get from cash has tragic outcome written all over it. If there is another bear market before interest rates normalize there will be an avalanche of dismayed investors panic selling their dividend stocks because they thought the stocks were "safe."

But it was with the last couple of sentences of his blog post that I took the greatest exception.  More precisely, I found that his example of Phillip Morris International (PM) to be misleading.  However, not because of what Roger included, but rather because of what he left out. I will elaborate more right after the following excerpt where he closed out his blog post:

"All stocks have strong and weak holders and I promise you that the weak holders will sell into the face of something bad--this is normal market behavior and has nothing to do with the merits of a stock or a strategy. I believe a client holding Philip Morris Intl (PM) is favorably viewed by the dividend crowd yet it went down 32% from when it spun off in March 2008 into the March 2009 low--weak hands not bad stock."

It is certainly possible, and perhaps even probable that Roger is correct in assuming that so-called "weak holders" may in truth do as he suggests and panic sell. However, I believe a lot of that "normal market behavior" can greatly be attributed to the preponderance of negatively biased information that is promogulated upon the general public, especially regarding equities and how risky they are.  In other words, if people were offered a more reasoned perspective, then perhaps much of the irrational and catastrophic panic selling that Roger alludes to could be avoided.

The following analysis utilizing the F.A.S.T. Graphs™ earnings and price correlated research tool on Philip Morris International illuminates the important parts that I feel Roger's comment left out. Roger is correct regarding how far that Philip Morris International's stock price dropped, as can be seen by reviewing the black monthly closing stock price line marked by the flags on the graph.  Phillip Morris International's stock price did, in fact, fall by the 32% plus number that Roger presented, and as he also stated, can most likely be attributed to "weak hands."  However, what his comment left out was the fact that the company's operating earnings were stable and continued to grow.  More simply stated, the stock price fell even though the company's operating results remained strong and solid.

Therefore, investors armed with that information could have seen that this low point in Philip Morris International's stock price represented an incredible opportunity not a high risk. The smart money (strong hands) would have added to their positions in this high-quality company that was continuing to post good results and raised its dividend every year, rather than sell out.  However, even if no one added money and simply held on they would have been given a substantial increase in their dividend each year and had their stock price rise from the original $50 a share to the more than $80 a share that it currently trades at (see flags on graph). The risk was not in the volatility itself, true risk would have been irrationally reacting to the volatility.

My point is that price volatility in itself is not risk, in my opinion, true risk is how people react to volatility when it occurs. Moreover, I believe that the reason there are so many "weak hands" is because of the weak information that investors are inundated with.  Knowledge is power, and I believe that if people were provided with greater knowledge on how equities, especially dividend paying equities, truly work, then we would be cultivating a lot more strong hands.


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