Why volatility is (in fact) a risk?

I come from the school of value investing. The idea of finding bargains and paying less compared to what it is worth excites me. In the light of the long storied success of value investing, some of its big proponents like Warren Buffett, Howard Marks, Monish Phabrai, etc. like to frequently point out to the general investing public that you should not fear the volatile markets and the effect that it is having in your portfolio. Well, right there, I have a problem.

I know what they are trying to say and what the rationale behind that perspective is. The idea is that if you have done a deep fundamental analysis about a certain company, you do not need to worry about the daily fluctuations. Even if the stock price drops 20 percent in a short period of time, you should not take any action. In fact, some might even go on to say "If that happens, you gotta buy more because it is now cheaper than what you had previously paid!" Most of the stock-picking value investors also would not hesitate to give examples from their own investment journey. And not surprisingly, they would tell the story of the time when XYZ stock had a large drawdown, but they went on ahead and doubled down on the position and after a few months there was a huge rebound and the trade eventually worked out. I am sure you have heard this kind of story before if you are into the investing game. Well, I would like to counter-argue by highlighting a very simple point that this is nothing but a classic case of survivorship bias. 

Think about it, why would they never tell the story of the time when they doubled down on a position and it failed so miserably that they had to shut down their entire fund? Well, who wants to share their failures? Nobody, right? Another point frequently brought by classic value guys is that standard deviation aka volatility should not be considered a risk. They argue that risk in investing is the probability of permanently losing your capital. Again, I get the idea behind this perspective. I mean, who cares about the Sharpe ratio and the standard deviations of the portfolio as long as you are making a big buck at the end of the period (whatever time frame suits you). Right? They like to also point out that individual investors should only invest that capital which even if they lose would not have a great impact on their personal life. 

Well, the flaw with that argument is that usually, people in the real world are investing their hard-earned money so that they can make some extra bucks aside from their personal income. Others might be planning for retirement and thinking very long term. If this is the case, when the market is volatile (as measured by standard deviation), it is natural for people to get anxious. Now, I am not preaching that they should liquidate their positions with a smell of volatility around but what I am trying to say is that sitting quietly on the side and expecting that it shall rebound soon also might be a mere fantasy. The downturn market has a natural tendency to take the form of a domino effect. 

Asness (2014) makes his argument by giving an illustration of an investor buying a cheap undervalued stock after doing deep fundamental research. The investor after doing her research has a conviction that the probability of permanently losing her capital is rather low. However, after a certain period of time, even though nothing has changed fundamentally, the price goes further down. Now here, this investor who fully believes that risk is only the permanent loss of capital and decides to just hold it for a very long period of time might make a healthy return on investment in the long term future. However, at the end of the year, the investor will have to realize that she lost money. YES, she expects to do well in the future but as of right now, although unrealized yet, BUT she is still losing. Furthermore, what if this investor we are talking about happens to be a fund manager? In this case, the manager has to report to the authorities and clients about the yearly/ quarterly performance. She cannot say in the performance report to clients that the NAV is still the same as it was at the start of the year. 

On an ending note, I would like to again quote Asness and say that "Risk is the chance you are wrong." And, it certainly does not have to be only the permanent loss of capital.

Asness, C., 2014. My Top 10 Peeves, Financial Analysts Journal, 70(1), pp. 22-30.