Novice Investing - Don't Shun Volatility

Date: Monday 01st 2008f December 2008 05:32:53 PM

Don't Shun Volatility - 08/12/2007

By: Hari Wibowo

Volatility is back. So, what? A couple of years ago, we have discussed about ways to reduce your portfolio's volatility. A general definition of volatility is: the characteristic of a share price that rise and fall sharply within a short-term period. In our previous articles, we gave you three tips to minimize your volatility despite the market condition. One is to pick companies with modest expectation; having a forward P/E of 10 or less. The next thing is to pick companies with predictable cash flow and dividend payment. Finally, we can reduce volatility by picking companies who is rich cash in the balance sheet.

But regardless, volatility can give individual investors several benefits:

1. Buying at cheaper price. When a stock is pounded down hard (presumably as a result of a panic), it will drop further and further below its fair value, enabling lucky individual investors to scoop it at a cheaper price.

2. Selling at a higher price. Conversely, when a stock is rising hot on euphoria, volatility will help propel the stocks further up, thereby enabling individual investors to sell at a higher price.

All these only meant one things. With volatility, your expected return as an investor will increase !! How about losses? Yes, stocks may go down hard soon after you bought it but the real key is the fair value of the stock. If you have calculated the fair value correctly, the short term sell-off will not affect you as long as you do not sell. But then again, most people may not have the necessary tools to calculate fair value of the common stock correctly.

Recent volatility originates from the concern of subprime blow up. To illustrate, two of the subprime concerns in the banking sector; Washington Mutual and Countrywide Financials has seen their price fluctuates wildly. Washington Mutual fell from $ 41 to $ 32.75 (-20%) in a span 2 weeks before rebounding to $ 35.95 (+9.7%) a week later. Similarly, Countrywide Financials fell from $ 34.25 to $ 24 (-29.9%) in a span of 2 weeks before rebounding to $ 27.75 (+15.6%) a week later.

Our sample portfolio, too is not immune to the recent volatility in the stock market. In a span of two weeks, Novell Inc. (NOVL) had fell from $ 7.64 to $ 5.7 (-25.3%) before settling at $ 6.42 (+12.6%), Magna International had fallen from $ 92.50 to $ 79.00 (- 14.5% ) before settling at $ 84.00 (+6.3%), Omnivision Tech had fallen from $ 18.50 to $ 16.00 (-13.5%) before settling at $ 17.50 (+ 9.3%). Finally, Lexmark had fallen from $ 44.00 to $ 37.66 (-14.5%) and never rebounds. As a result, our total portfolio return since inception (December 2004) has shrunk from +24% to +13% now.

As the subprime mess is unraveled, volatility will be the key of the game. However, hopefully we have convinced you that we will perform better if volatility is well and alive. Just make sure you have calculated the fair value of your holdings correctly.

END

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Disclaimer: The sole purpose of this article is educational. This article is merely the opinion of the writer and is not in any way a buy/sell recommendation regarding Countrywide Financial Corp. (CFC) or any other securities.

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