Factors and Favorites… You can think of investing as two separate investment decisions. Factors are criteria of an investment that provide above-average performance over the long term. The generally accepted factors are company size, volatility, quality, value, and momentum. Favorites are the weighting that each security is assigned in the portfolio. Favorites can be weighted by your confidence in the idea, equally weighted, weighted by company size, and weighted by factors or numerous other approaches. I will discuss the Volatility factor today.

Volatility, Safety, and Risk are sometimes used interchangeably in finance. Safety is never said to be a favorable factor, while lower Volatility is. Volatility is the amount the security bounces around above and below the security’s average price. We use the definition of Safety as the risk of permanently losing capital. History clarifies the thinking about Safety.

First, we have all heard that risk and reward are related. This is one of the theories that finance borrowed from great mathematicians working on gambling problems. For some, all investing is gambling. There was no need to question the proof of that theory in any securities purchasing. So, no one bothered. The next step in finance was to assume that ALL profits came from taking more risk, buying less safe securities. You can reduce risk by mixing securities so they exhibit their risks at different times (diversification), but you cannot avoid the risk-reward law. That is modern portfolio theory. We believe that purchasing some securities can be gambling. Let us call that speculation, and it is subject to the conventional thinking of risk and reward. Other purchases are appropriate business decisions. Let us call that investing, and it is subject to the reverse: lower risk leads to higher rewards. Just to be clear, we are investors.

There were critics of modern portfolio theory from day one. There was already evidence that Momentum and Value added to performance. Soon smaller Size companies, Quality, and Volatility were added to the factor list. Volatility is especially interesting. Lower Volatility is a factor. It is also appropriate to say that safety can be measured as volatility. We added Safety to our strategy twenty years ago because of outside research and because our back testing gave us positive results. We call Safety a factor. Our Safety measure is more comprehensive than volatility. We measure Risk and Volatility.

We use two of the four conventional factors in our methodology: Value and Quality. In addition, we use three other approaches that test well but are not recognized as factors yet — Growth, Safety, and Confirmation. We do use two more of the recognized factors in our strategy. We use Volatility as part of our Safety Factor and Momentum as part of our Growth factor.

The best performing securities for recent ten-year periods were AutoZone and DirecTV on the New York Stock Exchange, and Home Depot in the Dow Jones Index. All of them were in our portfolios. Three data points are not conclusive evidence of anything. However, I’ll take the profits anytime.

Sincerely,

Katz Family Financial