What Risk (Volatility) Means to Value Investors

Risk in investment is the likelihood of losing principal, the money you pay for an asset. Hence, correctly understand minimize risk is the priority for regular investors. Even venture capitalists or angel investors who are willing to risk losing everything in their investments carefully managed their risks (namely, an astronomical return that is higher than the likelihood of losing everything).

How Risk is Measured

Risk of an asset is often measured by price volatility (statistically, standard deviation of price). It should be noted that risk (volatility) is relative and is meaningful only in comparison with other assets. The higher the volatility is, the more significant price fluctuation is and the riskier an asset is. As it is shown in Why Value Stocks are Better Investment than Growth Stocks, high volatility results in high volatility drag, which eats away returns on investment or even principal itself.

Quantitatively, analysts often use the beta coefficient to measure volatility of a stock comparing to the market (usually an index such as S&P 500). A positive beta value means the price of a stock often swings in the same direction as the market. A beta of 1 indicates that the stock in question is as volatile as the market. The higher the beta is, the more widely its price swings, vice versa. On the other hand, a negative beta indicates that the price of a stock changes in the opposite direction of the market.

What Beta (Volatility) Coefficient Can’t Tell Us

Beta measures to what extent a stock moves together with the market. A high beta simply means the stock moves in the same direction of the market. When the market moves up, the stock price goes up; when the market plummets, the stock goes down with it. Ideally, investors hope to time the market and sell a stock at the peak price and buy a stock at its lowest point. Nonetheless, anyone who tries this approach would soon realize that it is nearly impossible to correctly time the market in a sustainable way. What it means is that beta (volatility) can’t tell us how likely the price will go up or down in the future. For this reason, if investors need liquidity for their investment and can’t afford short term losses (maybe because they need the money for other uses on short notice), then they may want to avoid stocks with high beta values.

In comparison, value investors don’t always avoid high volatility. Rather, they look for opportunities among volatile stocks that maintains good financial fundamentals but suffer from more significant price drop than the market. To avoid losses, value investors protect themselves with significant “margin of safety” by buying a stock at a price much lower than its intrinsic value and waiting for the price to meet its intrinsic value. For this strategy to work, value investors are not very concerned about short term losses caused by volatility.

A Story of Mine

While we were still building this website, the algorithm of our undervalued stock index indicated that Norwegian Cruise Line (NCLH) traded at around $8 per share was significantly undervalued comparing to its peers. Even though NCLH has a beta of 2.61, it is mostly attributed to the suspension of cruising business due to the COVID-19 pandemic. Believing then (March) that the pandemic would be over soon, I bought some NCLH shares at $8, partly because of its value and partly because of my belief in the company’s long-term success. Very quickly, its stock price rebounded and I bought more of it. Eventually, the investment resulted in an 80% increase at its peak level on June 8, 2020, partly thanks to the expectation of resumption of business. Unfortunately, “bad luck” struck. The pandemic in the US worsened, particularly in the South. CDC extended the suspension of the cruising industry. Consequently, NCLH drop back to below-$20 level and has fluctuated between $15 and $17 since then.

Year-to-date price movement of NCLH
NCLH Year to Date Price Movement

An 80% return from NCLH.
A screenshot of my Roth IRA

I could have sold my holding at above $20, but I chose not to. In retrospect, it might seem to be a mistake. Nonetheless, I still believe that the stock is still undervalued at around $15 per share (for a matter of fact, NCLH showed up again as the 8th most undervalued stock in the consumer discretionary sector on August 21). Once the CDC allows the company to resume sailing, its stock price would have greater potential than 80% return in the long term. While in the short term, I will just wait for the “storm” to pass.