4♣ – Volatility is not Risk

Volatility is not Risk - Risk is the danger that you might lose purchasing power

Volatility is not Risk

This post is part of the MoneyDeck series, a pack of 52 playing cards that describe 52 “golden rules” for Private Investors in the UK.

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Volatility is not Risk – Risk is the danger that you might lose purchasing power

Stock prices will always be far more volatile than cash equivalent holdings. Over the long-term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. – Warren Buffett

Risk is not knowing what you’re doing. If you know who you’re dealing with, and know the price you should pay, then you’re not dealing with a lot of risk. – Warren Buffett

Risk means more things can happen than will happen. – Elroy Dimson

We drive into the future using only our rear-view mirror. – Marshall McLuhan

Don’t just do something, sit there. – Stock market proverb

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Blame Harry Markowitz.

Back in the 1950s, the future Nobel laureate came up the idea that the standard deviation of returns from an investment (a statistical measure used to denote volatility – beta is the equivalent measure relative to a market or index) was a good proxy for its riskiness.

  • It helped that it made the maths neat on his model for selecting an efficient portfolio.

Now lots of people look at the variability of historical returns to decide how much risk they would be taking on with a given set of assets.

  • The more the price of something jumps around, the more “risk” that you are taking on.
  • The less it jumps around, the less you need to worry about it.

But this about as true as the Efficient Market Hypothesis (EMH).

  • Which is to say, it just isn’t true.

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In fact, the conflating of volatility and risk follows directly from the EMH:

  • If the markets know everything, and everything is reflected in the price, then a volatile price reflects uncertainty and inconsistency in the stock

But they don’t, and it isn’t, and it doesn’t.

Modern Portfolio Theory also tells us that risk (volatility) and expected returns are proportional – that an investor must take on additional volatility to gain extra returns

  • That one hasn’t turned out to be true either – low volatility stocks have outperformed in recent decades.

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There are five basic problems with volatility:

  1. we have an asymmetrical attitude to volatility
    • nobody cares about volatility to the upside, we just don’t like big drops in our wealth
    • Modern Portfolio Theory equates big upward moves with big drops
  2. volatility is backward-looking
    • it’s the “rear-view mirror” of risk management
  3. the underlying calculations assume a normal distribution of returns
    • in practice returns are skewed (positively or negatively, according to asset class), peaky (have positive kurtosis) and show fat tails
  4. volatility can and will change, often in dramatic fashion
    • past volatility is no guide to the future
  5. volatility is often highest when asset prices are low (in bear markets)
    • this acts against investors buying assets when they are cheap, and instead encourages purchases during bubbles

To expand on the third point, individual asset returns are combined into portfolios using correlations.

  • These correlations are unstable and tend to increase during periods of stress, increasing true risk.

To elaborate on the final two points, junky assets will probably do well for a time (during the bubble phase) before they blow up.

  • This does not mean that they are not risky at the moment before the bubble pops.

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If the variability of historic returns is not the risk that we are looking for, what should we put in its place instead?

To answer this question we need to go back to the beginning. What is the purpose of investment?

  • What is the purpose of investment?

Savings are consumption deferred into the future, and the purpose of investing is to protect and grow that purchasing power.

  • So the risk we face is the chance that our purchasing power will be lost.

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Depending on the assets we hold, the detailed mechanism by which purchasing power shrinks will vary.

Key amongst the threats – and this seems strange to say in today’s economic climate of negative interest rates and deflation – is inflation.

  • That is why cash, which delivers low but stable returns, is amongst the riskiest assets for the long-term investor since it rarely keeps pace with inflation.

Short-term investors need to worry about volatility, but long-term investors do not.

  • And we are all long-term investors, whether we realise it or not.

If you have a short-term (5 years or less) need for funds, keep some cash on hand.

  • You don’t want to be a forced seller in a bad market.

But if you don’t have a short-term need, then don’t worry about volatility.

  • Tune out the noise.

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What we need to do as investors is to understand the range of possible outcomes for the assets we own, and put together a portfolio to offset the real risks they each face.

How we do this will depend on our investing style – a momentum trader won’t approach the problem in the same was a deep value investor.

But company and country fundamentals, industry and sector disruption, fiscal and monetary policy, and global macroeconomics will be involved.

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If volatility is so wide of the mark in assessing risk, why is it so popular?

  • As well as Harry, we can blame the professionals.

The investment industry is not currently set up for high performance.

  • The interests of investors and asset managers are not aligned
  • The annual percentage fee on assets under management means that this is really a market share game

Investment managers need to market their services, and it’s easier to do this with a common measure of “risk” that to go to all the trouble of modelling future returns.

  • Using volatility as risk allows managers to match clients with varying risk appetites to funds of varying volatility

As we said earlier, the standard deviation of historic price variability makes the maths easy.

  • Quarterly reporting of (price) performance also favours the smoother path against the superior destination.

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But you don’t operate under the same restrictions as the professionals.

So remember, Volatility is not Risk – Risk is the danger that you might lose purchasing power.

Until next time.

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Mike Rawson

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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4♣ – Volatility is not Risk

by Mike Rawson time to read: 4 min
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