Risk and Volatility

Physician's Money Digest, September 2005, Volume 12, Issue 13

Many otherwise savvyinvestors do notunderstand the differencebetweenrisk and volatility.Their perception is that an investmentwith above-average volatilitymust be accompanied by above-averagerisk, which isn't necessarily true.Being able to distinguish one fromthe other is important.

For example, like most people, youprobably consider government bondsrisk-free. After all, the US governmenthas never defaulted on its debt.Buy a 10-year Treasury bond todayand you are guaranteed to get yourmoney back in 2010. No risk, novolatility, right? Wrong.

Suppose you purchase a 10-yearTreasury bond issued 3 years ago thathas 7 years until maturity. The couponis 3%, but since issuance interest rateshave risen from 3% to 6%, the bondhas depreciated from $1000 to $820.The bond's volatility makes it appearrisky—after all, it has depreciated 18%in just 3 years. But in this case, thevolatility does not entail risk if yourinvestment horizon matches the bond'smaturity date, since the governmentguarantees its value at maturity. Thevolatility could involve risk for someoneforced to sell the bond before thematurity date.

Market Uncertainty

A related and equally importantconsideration is uncertainty. The marketshate uncertainty and, more oftenthan not, can't differentiate uncertaintythat includes risk from uncertaintythat does not.

As an example, let's assume a companyis considering a dividend increaseon its stock over the next 30 days.Your analysis tells you the stock is fairlypriced at its current dividend rate. Adividend increase will make the stockworth more, and without a dividendincrease the stock will be worth its currentprice. As the date for dividenddeclaration grows closer, the stock sellsoff due to uncertainty about the dividendincrease. Knowledgeable investorswill take advantage, realizingthere is no risk, only uncertainty. Theuncertainty is that as a physician-investor,will you get your current dividendand have a fairly valued stock,or will your stock increase its dividend,appreciate in value, and increase yourcash flow? This is a heads you win,tales you don't lose situation. There isa significant amount of uncertainty, yetno real risk.

Here's a simple comparison ofuncertainty and risk. If you flip a coinone hundred times—heads you get $1,tails you get $2—there is plenty ofuncertainty but no risk. Either wayyou will come out ahead. The 2004presidential election also illustrates thispoint. Before the election, the marketswere directionless and displayed exceptionalinstability. As soon as we hada winner, the markets stabilized andtook off because the doubt wasresolved. The risk remained but theuncertainty was gone.

A real-life example is HealthSouth,where criminal and regulatory investigationscreated great uncertainty andvolatility, like a mini-Enron. However,there is one major difference betweenthe two. HealthSouth has hard assets,such as hospitals and the like, worthtriple its liabilities. There was doubtabout when investors would be paid,but not if they would be paid. Investorsrecognized this and boughtHealthSouth bonds for as little as 5cents on the dollar. In less than a year,they were repaid 100 cents on the dollarwith 3% interest to boot. Therewas uncertainty and volatility, but noreal risk. The company's profitablehospitals and medical facilities backedup the bond's return of capital bymore than 300%. Investors unable todistinguish between uncertainty andrisk were forced to prematurely liquidatetheir positions. Their perceptionof HealthSouth was distorted by theprevious but very different circumstancesat Enron and MCI.

Hedging the Risk

The HealthSouth example is not anuncommon one. The hedging strategyused plays against the inherent volatilityor uncertainty of a market or industry.There remains a misconception amongmany otherwise savvy investors regardinghedge funds. Most people probablystill regard hedging as a high-risk strategy.Of course, there are many differentmethods of hedging, but the industry asa whole has been saddled with a shakyreputation because of the perennial fewbad apples, such as the Long-TermCapital Management blow up in 1998.The publicity from such an event skewsoverall market perceptions while mosthedge fund managers, among thesmartest and most sophisticated assetmanagers in the financial community,quietly continue to earn good risk-adjustednumbers for their investors.

Volatility is one of the primary driversof hedging strategies. Hedge fundmanagers typically rely on the constantmovement of equities to provideopportunities for enhanced investmentperformance. The volatility providesthe performance opportunities, but therisk is minimal for physician-investorswith sufficient time horizons, assumingyou have an experienced and competentfinancial advisor.

In a risk-adjusted hedging strategy,physician-investors may invest in astock at $100 a share because webelieve it will be worth $125 a shareover the coming 12 months. Investorsalso buy a put at 95, so if some unforeseenevent occurs (eg, a terroristattack, oil embargo, the CEO's planegoes down, etc) and the stock drops to30, you only participate in the dropdown to 95. The strategy limits yourexposure to a 5% risk, while leavingthe $25 upside intact, regardless ofhow much uncertainty or volatility towhich that stock may be subject.

So while uncertainty and volatilityare predictable and omnipresent inthe markets, risk can be defined andcontrolled. Understanding the differencebetween risk and volatility canmean the difference between investmentgain and loss. Investing fundamentalsdon't change.

Steven Holt Abernathy is principal and chairman

of The Abernathy Group in New York, NY.

The organization provides wealth management

and financial services to medical professionals.

It has been ranked the top money

manager in the nation 8 times in the past 12 years by

Nelson's. Mr. Abernathy welcomes questions or comments

at 212-293-3469 or sabernathy@abbygroup.com. For more

information, visit www.abernathyfinancial.com.