Value and Volatility

Investors maximize the risk adjusted returns of their portfolios. This means investors do not just maximize expected returns, and investors do not just minimize risk. Investors try to maximize the return-to-risk tradeoff subject to other constraints.

Risk is often thought of as volatility in academics. However, many practitioners, including Warren Buffet, think of risk as permanent loss of capital. Practitioners rarely debate the volatility of their investment ideas or portfolios. Practitioners more often describe how their estimate of intrinsic value differs from the value of the market. Practitioners invest in stocks with wider differences between their intrinsic value and market value. This distance provides a sense of safety.

When academics talk about portfolios in terms of returns and volatility, they focus on how stocks covary with each other. If all stocks are perfectly correlated, then the volatility is higher than if the stocks are imperfectly correlated. Diversification is easier to achieve if stocks are less correlated, and there are no benefits to diversification if stocks are perfectly correlated.

However, diversification can also be by multiples. Do you care more if the stocks in your portfolio covary together in the short term? Or do you care more whether the B/M value of stocks in your portfolio covaries more together? I would say you care whether B/M value is correlated because if B/M increases for all stocks in portfolio, then portfolio has seen a big decline in value independent of the actual book value of the companies you own.

One reason why we don't think about multiples is that we don't observe book value in real time. This makes it hard to judge whether stocks covary together in terms of multiples.