The investment world can be split into many camps, but, in discussions of risk, owners and custodians of capital, their agents, academics, analysts and journeymen pitch their tents firmly in one of two camps. In one field we have those for whom risk means the probability of a permanent loss of capital which would cancel all hope of achieving an investment objective. This group will oft reference the Sage of Omaha, Warren Buffet, who has been robust in his observation that risk is not synonymous with the preferred definition of the other camp – volatility.
In business school classrooms, university lecture halls and many of the world’s largest asset managers it has been standard practice to use volatility, or the “spikiness” of a price chart, as a proxy for the risk of a tradeable asset, sector or asset class. The use of volatility stems from the study of the role markets play in setting the price of individual assets in the short term. It is the role of markets to rapidly assimilate information and establish a price. The mechanism by which this is achieved is the assessment of future returns by a myriad of market participants, each of whom will establish a fair value and then trade the asset using deviations from fair value to determine the buy or sell decision. For assets with a clearly defined profile of cash flows, such as a bond, or the equity of a utility company, the assessment will not differ greatly from one participant to the next over short periods of time, and thus, volatility will be low. On the other hand, where there is significant divergence of opinion on the likely outcome for a company, volatility will be higher. Volatility is therefore a measure of the difficulty short term price setters have in understanding likely outcomes for long duration assets.
Friends of Warren would chuckle at the preceding paragraph. The reason for this is that the speculator’s measure of risk is the long-term investor’s friend. Volatility provides long-term investor with the opportunity to reinvest cash flow into an asset at times when the market’s short term view of the asset is unfavourable. The result is that the long-term investor can enhance returns by taking advantage of the market’s near-sightedness.
The use of volatility to assess risk of individual assets is extended to analysis of portfolios and plays a central role in the optimistically named “Modern Portfolio Theory” written by Harry Markowitz in 1952. Sorry Harry, no longer modern but sadly still a theory. We find that the volatility camp will measure the up and down movements of a portfolio and use this as a measure of the risk being taken by the portfolio manager. We now find ourselves in a rather mixed up world with a short-term measure of risk being applied to an activity which is (hopefully) undertaken with a long-term perspective.
Some long-term investors doggedly shun any use of volatility as a measure of risk. We take a more nuanced view. As a measure of investment risk, volatility falls short and simply minimising volatility is not a sure way of avoiding permanent capital loss. This can only be achieved by in depth analysis of prospective investments and selection of only those that meet a sensible set of investment criteria. However, for as long as capital is owned or placed in the trust of humans who bristle with the emotions of fear and greed, volatility will represent a degree of behavioural risk, which, for want of a better expression we might describe as the danger of doing something stupid: a highly volatile portfolio will present, with some regularity, an individual or committee with the opportunity of turning a short term disappointing performance into a long-lasting destruction of capital. The sage advice at these times is: “Don’t just do something, sit there”.
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