A couple of months ago I saw John Wilson, CEO of Sprott Asset Management, speak at an alumni dinner; we both graduated from the Sprott School of Business at Carleton University. Despite our common education, we come from different schools of thought on investing. When John was speaking, I tweeted some of the things that he said. Looking back, one quote that I find particularly interesting is, “Investing success isn’t about beating the benchmark, it’s about not losing money.”
I understand John’s sentiment from a behavioural point of view, people don’t like to see the value of their account decrease. It is, however, imperative for investors to have an understanding of the difference between volatility and risk in order to have a successful investment experience. Although a riskier investment will tend to display higher volatility, there is an important distinction to be made between the two terms.
Volatility relates to the dispersion of market returns over time, or the tendency of the value of securities to move up and down as new information develops. Over long periods of time, the indexes that represent the market have tended to increase in value despite periods of volatility. Investors expect higher returns for holding more volatile investments.
Risk is the risk of losing money, which ultimately means either selling out of the market when an investment’s value is below its original purchase price, or having an investment’s value go to zero. The first risk is behavioural and the second is the specific risk attributed to a particular investment, called non-systematic risk. An example of non-systematic risk is the risk of a company going bankrupt.
The non-systematic risk of any individual investment can be almost completely eliminated from a portfolio through proper diversification. The biggest risk that investors face is themselves, their own behaviour. John Wilson’s idea of ignoring benchmarks in favour of not losing money is feeding directly into the psychology that causes investors to make bad decisions based on their emotions. Buying into this mindset causes investors to accept returns below the benchmark because they do not understand the distinction between volatility and risk.
It is the job of a professional money manager to construct a portfolio with a tolerable amount of volatility over an appropriate period of time for a client’s particular situation and preferences. When this is done properly, the investor will be positioned to capture the returns of the market without the risk of their own behaviour getting in the way.
Original post at pwlcapital.com