Many finance professionals believe the stock market is basically efficient. That is, prices of stocks are fairly priced, and therefore the only way to generate higher returns is by taking more risks. This group also believes that risk is defined by price volatility, so the more volatile the stock, the higher its risk.
Value investors, of course, not only reject the fact that the market is efficient (for a terrific essay on the subject by Warren Buffett, see here
), but also find flaw with the definition of risk. To value investors, risk represents the potential that the underlying
business is or becomes worth less than anticipated, and this is often times completely unrelated to a stock price’s volatility. Value investors believe volatility could be caused by the market’s general level of fear, supply/demand characteristics of various securities
at particular points in time, and other psychological factors unrelated to the underlying business.
According to Roll, company specific risks play only a very small role in a stock’s volatility. If this information is accepted, it seems ludicrous to believe a stock’s volatility – rather than the fundamental business/financial risk of the underlying company itself – is what governs an investment’s risk level. Investor confidence, interest rate
s, and the stage of the business cycle all play far larger roles when it comes to volatility!
Value investors who take advantage of volatility, rather than fear it by equating it with risk, position themselves for market beating returns!