Risk and Return: Holding Period in Visual Studio .NET

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Warren Buffett suggests that returns from quarter to quarter, or even year to year, are not very important if the returns in the long run are predictable Volatility of returns in the short run should not be the main criterion for assessing risk What matters is the return at the end of the investment period Assume that you invest $1,000 in a 30-year Treasury bond yielding 5 percent If your investment horizon is 30 years, you will earn $50 in interest per year, plus the principal of $1,000 at the end of 30 years However, the market price of the 30-year bond will change from month to month depending on the market interest rate, which could create signi cant short-term volatility If you have a 30-year investment horizon, should you de ne the monthly volatility of bond prices as risk No The investment is risk-free so far as the payments are concerned in nominal dollars Consider the same 30-year bond investment from the perspective of a person with a one-year investment horizon This
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Risk and Volatility: How to Think Pro tably about Them
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investor can lose a signi cant amount if interest rates rise because the prices of long-term bonds fall as interest rates rise In early 2009, the 30year Treasury bonds declined in price by 20 percent when the interest rates went up by about 15 percent Let s move on to stocks and return volatility Assume that an insurance company has underwritten a large number of hurricane insurance policies in Florida You are probably already thinking of Berkshire s insurance business The insurance company will show high pro ts in the years Florida is not hit by a major hurricane Since the stock market usually focuses on the short term, you should not be surprised if the company s stock enjoys high returns in those years But during a year in which a major hurricane hits the state, pro ts will go down and the stock price could be bid down substantially However, Berkshire s management is willing to accept volatility in reported results, provided there is a reasonable prospect of long-term pro tability, writes Buffett4 An investor who recognizes that a one-time event may not affect the underlying long-run risk pro le of the company is likely to invest more in a good insurance company when the stock price goes down The main lesson to take away from this discussion is that there is an interaction between the length of the holding period and risk, especially if you think of risk as downside risk This applies to both bonds and stocks If stock returns from one period to another were statistically independent, the length of the horizon would not be important However, there is ample empirical evidence that stock volatility in the long run is lower than volatility in the short run Thus, the length of the investment horizon should be an important consideration for an investor
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Volatility Offers Opportunities
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An investor who views volatility as risk will be tempted to avoid volatile stocks, which may not be the right investment approach Indeed, Buffett suggests just the opposite: In fact, a true investor welcomes volatility 5 As an example, consider volatility and rm size Smaller companies are usually more volatile than larger companies, probably because a small number of buy and sell orders can dramatically change the stock prices of smaller companies But small companies need not be fundamentally
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risk, diversification, and when to sell
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risky, especially when you know a lot about the speci c companies you plan to invest in Opportunities are more likely to arise in smaller companies than in larger companies Buffett has expressly said that if he had a smaller amount of money to manage, he would be able to generate higher returns Since the Berkshire investment portfolio is huge, Buffett restricts himself to investing in large companies However, if you follow an industry closely enough, you should not ignore smaller companies Increased volatility does not imply increased risk because there are many factors that can cause volatility that have nothing to do with risk Professor Robert Shiller of Yale University has often argued that the stock market is too volatile to be easily explained by rationality alone He concludes, Prices change in substantial measure because the investing public en masse capriciously changes its mind 6 Usually, after an earnings announcement, a company s stock price becomes more volatile The stock price is also more volatile after a stock split because the price per share decreases Such a rise in volatility does not necessarily mean that the stock has become more risky Volatility also increases when the Federal Reserve announces interest rates or when other macroeconomic data are released Most company fundamentals are not affected by these news items, and you should buy more of your favorite stocks whenever Mr Market is willing to sell them to you at a lower price because of market volatility In October 1974, the Dow Jones Industrial Average (DJIA) was below 600 after having declined 40 percent, and when Forbes asked Buffett how he contemplated the stock market, he shot back, Like an oversexed guy in a harem This is the time to start investing 7
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