What Volatility Really Means

By Chris Gallant | May 25, 2006 AAA

When it comes to my personal portfolio, I'm usually a fan of low-risk, well-established companies that are boringly consistent. But like most investors, I also occasionally add a risky stock or two to my holdings when I believe the growth prospects outweigh the risks and short-term volatility. Generally speaking, the logic most of us investors use in these situations sounds something like, "This company's stock price sure is volatile, but I'm willing to tolerate this risk because their growth prospects are so terrific."

But, exactly how bumpy of a roller-coaster ride are you signing on for when you decide to invest in one of the market's many "volatile" stocks? Let's take a closer look into share price volatility and see what it really means for investors who own volatile stocks.

Consider one of the Investopedia Advisor's Swing For The Fences Portfolio holdings, II-VI Inc (IIVI). Pronounced "two-six", the $600 million company manufactures lenses and other optical components that are the key ingredients built into industrial-strength lasers. II-VI's share price has produced some remarkable growth for its investors since the turn of the century. Investors who bought IIVI at the start of the year 2000 and held until May of 2006 have earned an outstanding 33.5% annualized return.

Of course, during this time, the high-flying II-VI had a much greater chance of losing some, or even all, of its shareholders' equity than that of the stock market's boring (but safe) heavyweights. A reality that, even after all this time of 33.5% annualized gains, leaves the market trading II-VI today with a stratospheric Beta of 2.92 -- almost threefold the volatility of the overall market.

Okay, so that's a "risky" company, but what does being a "safe" company really mean? Consider 3M Co. (MMM) for a minute. The company is fairly safe -- it has a diverse product line, scores of patents to beef up its economic moat, and with a $66 billion market capitalization, enough size to protect itself from poor economic conditions. And what is the good ol' beta measurement for MMM you ask? A trusty 0.95 -- even less volatility than the overall market and less than one-third that of II-VI. Of course, that kind of safety comes at a steep price. During the same holding period since the start of the millennium, MMM shareholders only reaped 15% annualized gains.

And while there's nothing wrong with 15% per year, it's a far cry from the market-crushing 33.5% annual gains enjoyed by IIVI shareholders. So it's no surprise that most investors are always on the hunt for a company like II-VI, and are often more than willing to stomach the risk that comes with them.

But, like every other area of life, the stock market is not immune to human nature, and when it comes to digesting share price volatility, it's a lot easier to talk the talk than it is to walk the walk.

In other words, it's really quite easy to say, "I accept the high risk of this growth stock," when you first buy it, but all of sudden the same sentence becomes excruciatingly difficult to utter when you wake up one morning to find your stock's price has plunged 10% at market open because it's quarterly numbers didn't grow as quickly as Wall Street analysts expected.

Let's go back to our comparison of II-VI and 3M for a moment. While long-term II-VI investors ended up with 33.5% annualized gains over the five-plus years they've owned the stock since 2000, guess how many mornings they woke up to find the stock spiked up or down by more than 10%?

The answer to that question is an astounding 50, yes fifty, days! (Click here to download an Excel spreadsheet with our calculations -- note, 600KB file size). That averages out to about one 10% or greater single-day spike each and every month!

And while 32 of those 50 days were up days, 18 of them were down days. Think it's hard watching your stock plummet once? Try making a veritable round of golf out of the affair and doing it eighteen times.

Now, to be fair, as compensation for this roller-coaster ride, IIVI did provide roughly double the return of a 3M's low-risk, 15% annualized gains during this time period. But how many single-day price shocks did 3M shareholders have to endure for their paltry 15% returns?

One. And it was a 10% gain.

Now I've got nothing against Beta. Or standard deviation, or even variance for that matter. But I think it's important for investors to realize just what kind of roller-coaster ride they're getting on board when they punch their ticket for a "volatile" stock like II-VI.

You can't expect to be 367% higher than you were back in January of 2000 (as II-VI shareholders are today), unless you're willing to stick with your stock through each and every jolt the market sends through its share price. If you're going to get nervous every time your stock drops 10%, chances are you'll either sell for a loss and ruin whatever gains your stock would have given you, or you will give yourself a nervous breakdown fretting about the price each day.

Either way, you'd undoubtedly be much better off sticking to risks/reward scenarios you can tolerate. And don't worry, 15% per year can still let you retire more than comfortably.

But if you're interested in risking some of your capital and can handle the market's ups and downs, high-fliers such as II-VI may be just the stock for you. It's just these types of stocks we pick for the Swing For The Fences Portfolio of the Investopedia Advisor, and as of today our Swing picks have averaged gains of better than 37%.

If that sounds interesting to you, Click Here to take advantage of our 30-day free trial and review all of our Swing For The Fences selections.

Alternatively, if the more interested in stable and "safe" returns we also offer Investopedia Advisor members access to our Core Holdings portfolio. In this portfolio we focus on companies whose stable and more consistent growth coupled with their sustainable competitive advantages offer market-beating returns with less volitility.

Either way we'd be happy for you to test drive the Investopedia Advisor absolutely free for a full 30 days and check out all of our stock ideas -- Click Here to take advantage of our Free Trial offer.

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