Author Topic: Volatility and Risk are Not the Same Thing  (Read 4536 times)

hodedofome

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Volatility and Risk are Not the Same Thing
« on: November 12, 2014, 03:38:37 PM »
Most people think of Risk and Volatility as being the same thing. They are not.

Volatility is usually defined by the standard deviation of returns of an asset. How much something moves up and down over a period of time.

Risk can be many things - it can be underperforming your objectives, losing a good chunk of your money, or losing all your money.

Just because something is volatile, doesn't necessarily mean it is risky. Likewise, just because something ISN'T volatile, doesn't mean it ISN'T risky.

A bond is generally considered not very volatile, yet in the right environment it could be very risky (inflation or rising interest rates). As well, the depositors of Cyprus banks experienced roughly 0 volatility for years, and then found out that 47.5% of their savings above $132k were gone overnight. It was a very risky investment, even though it's historical volatility was almost nothing.

Likewise, an investment or strategy could be very volatile yes LESS RISKY in the right environment. Going back to the bond example, an inflationary environment may be risky for bonds - but stocks, even though they are more volatile, may be less risky at that time. Or perhaps gold, which has very high volatility, may even be the least risky in that environment. Buffett, although he has experienced high volatility over his investing lifetime, would tell you that he was always buying the least riskiest investment at the least riskiest time (margin of safety).

When designing your portfolio, think first about the RISK. What could go wrong? What is the chance I lose a lot, or all, of my money? What's the worst thing that could happen? Risk is ultimately more important that volatility. Automatically throwing assets into volatility buckets (this is less volatile therefore it's less risky, etc etc) and assuming you have managed risk properly is putting the cart before the horse.

gimp

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Re: Volatility and Risk are Not the Same Thing
« Reply #1 on: November 12, 2014, 09:42:11 PM »
Least riskiest :)

Good post.

Radagast

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Re: Volatility and Risk are Not the Same Thing
« Reply #2 on: November 13, 2014, 08:32:49 AM »
I agree, and almost considered posting something similar.  Volatility is the near-certainty that your investments will go up and down a certain amount. Risk is the possibility that your money won't be there when you need it.

brooklynguy

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Re: Volatility and Risk are Not the Same Thing
« Reply #3 on: November 13, 2014, 10:00:21 AM »
"Risk" is a term that is meaningless in a vacuum.  It is the exposure to the chance of something happening.  When you talk about risk, you need to be clear about what that something is.  The risk that an asset's market value could change significantly in the short term (i.e., volatility) is important if you need to liquidate your investment in the short-term, and not important if you don't.

nereo

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Re: Volatility and Risk are Not the Same Thing
« Reply #4 on: November 13, 2014, 10:22:50 AM »
amen brother!

Radagast

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Re: Volatility and Risk are Not the Same Thing
« Reply #5 on: November 13, 2014, 11:56:33 AM »
I suspect I am arguing despite being in agreement, but...

"Volatility" is a term that is meaningless in a vacuum.  It is exposure to something happening.  When you talk about volatility, you need to be clear about why it matters.  An asset's market value could change significantly in the short term which is important if you need to liquidate your investment in the short-term (i.e., risk), and not important if you don't.


Of course volatility is just one of many types of risk, and is one of the more predictable. That is, it is a known unknown. Even then it is not really a risk. The risk is a prolonged bear market, or a market plunge at the exact time you need money desperately. Volatility by itself is just noise. There is no way to prevent volatility (without reducing returns), but there are ways to protect against risks, including market declines.

KingCoin

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Re: Volatility and Risk are Not the Same Thing
« Reply #6 on: November 13, 2014, 04:40:10 PM »
As others have implied, this is mostly an argument about semantics. You're of course free to define risk however you please.

There are exceptions to prove every rule, but bank accounts are typical low risk and minimally volatile, bonds are typically moderate risk and moderately volatile, and micro-cap stocks are typically high risk and highly volatile. Risk and volatility simply go hand in hand. If they didn't, you'd always prefer a lower volatility asset with higher risk. In fact, trying to describe a high risk asset with low volatility or a low risk asset with high volatility is inherently vexing.

Consider: high risk assets have higher return than low risk assets. High volatility assets have higher return than low volatility assets. Therefore, it's pretty clear the concepts of risk and volatility (at least as typically defined in most financial literature and theory) are inextricably linked. Risk is used interchangeably with volatility, and rightly so; it's the bedrock of modern porfolio theory. Most volatility vs return charts label the X axis "volatility (risk)" just to make the point clear.




« Last Edit: November 13, 2014, 05:26:58 PM by KingCoin »

hodedofome

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Re: Volatility and Risk are Not the Same Thing
« Reply #7 on: November 13, 2014, 06:13:29 PM »
Yeah, until they found out that low volatility stocks outperformed the market. Then the theory kinda failed a bit.

Radagast

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Re: Volatility and Risk are Not the Same Thing
« Reply #8 on: November 13, 2014, 07:46:28 PM »
Apparently not semantics. I believe Hodedofome's point (mine anyhow) is that risk has little to do with volatility, and even less to do with standard deviation. Once you express something as a standard deviation it becomes quantifiable, controllable, even predictable in a non-predictable sort of way. Risks are mostly beyond expression as a standard deviation. For example, right now I am reading Bogleheads Guide to Investing, which was published in 2005. They mention a Lehman Brothers bond index in several places. Now, based on standard deviation and the book, you might think investing in a bond index through Lehman Brothers (over 100 years old!) was close to risk free. And you would have been completely wrong.

Volatility can indicate an investment is not a reliable source of income, especially over defined lengths of time, but it is not a good indicator of risk.

KingCoin

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Re: Volatility and Risk are Not the Same Thing
« Reply #9 on: November 13, 2014, 08:41:47 PM »
Apparently not semantics. I believe Hodedofome's point (mine anyhow) is that risk has little to do with volatility, and even less to do with standard deviation. Once you express something as a standard deviation it becomes quantifiable, controllable, even predictable in a non-predictable sort of way. Risks are mostly beyond expression as a standard deviation. For example, right now I am reading Bogleheads Guide to Investing, which was published in 2005. They mention a Lehman Brothers bond index in several places. Now, based on standard deviation and the book, you might think investing in a bond index through Lehman Brothers (over 100 years old!) was close to risk free. And you would have been completely wrong.

Volatility can indicate an investment is not a reliable source of income, especially over defined lengths of time, but it is not a good indicator of risk.

The fact that high volatility investments outperform low volatility investments isn't some sort of anti-efficient market arbitrage. You need excess compensation for excess risk, otherwise no one would invest in volatile assets. And this isn't some convenient hand-waving theory, it's readily demonstrable in the historical data (not over every period for every asset class, but generally). Just look at the graphs above.

Oh, and the low volatility of bonds includes the financial crisis and Lehman failures. It's ridiculous to claim a low risk asset class is high risk simply because of a couple historical examples. No one is claiming that every bond and bond fund is low risk over every period; we're talking about a diversified asset class over time.

Understanding the connection between risk, price volatility, and expected returns is absolutely critical to good investing.


(Oh, and the Lehman bond index that was being referred to was likely just a benchmark index created by Lehman (like the S&P500 for stocks), not a fund that had exposure to Lehman credit risk (as their money market funds did).)
« Last Edit: November 13, 2014, 08:59:23 PM by KingCoin »

Radagast

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Re: Volatility and Risk are Not the Same Thing
« Reply #10 on: November 13, 2014, 10:00:28 PM »
Right, volatility is one of the most predictable types of risk, which ends up making it not especially risky. Everyone knows exactly how to account for it. But the most devastating risks do not show up in volatility measurements. The point isn't that bonds are risky, just that there are risks to bonds (and all investments) that don't show up in day-to-day or even year-to-year happenings.

KingCoin

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Re: Volatility and Risk are Not the Same Thing
« Reply #11 on: November 14, 2014, 05:11:12 AM »
Right, volatility is one of the most predictable types of risk, which ends up making it not especially risky. Everyone knows exactly how to account for it.

Yes. This kind of goes back to semantics. Do you want to define risk as price volatility over the short term (as most do), or as performance over, say, a 20 year period, where you could reasonably argue that a bank account is more "risky" than bonds or stocks.

Saying that everyone knows how to account for volatility is probably overly generous.

But the most devastating risks do not show up in volatility measurements. The point isn't that bonds are risky, just that there are risks to bonds (and all investments) that don't show up in day-to-day or even year-to-year happenings.

It's true that all assets have tail risks, and short term volatility isn't necessarily indicative of volatility next year or even next week. However, spikes in volatility generally happen in concert across asset classes. So take a look at the relative performance of government bonds vs corporate bonds vs stocks in 2008 and you'll see that the investment theory played out just fine. Correlations aren't perfect of course, which is why one benefits from a diversified portfolio. However, during the crisis, you would have been best off in the historically least volatile (least risky) asset classes, and worst off in the most volatile (most risky) assets classes.

hodedofome

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Re: Volatility and Risk are Not the Same Thing
« Reply #12 on: November 14, 2014, 07:38:34 AM »
The purpose of my post was to get people thinking about risk before anything else.

Many investments that people own do not have daily quotes - real estate, privately held companies, collectibles, life insurance, annuities, etc. It's darn near impossible to measure the volatility of those investments. But if we can think about the risk(s) first (or margin of safety or however you want to define it), then that'll get us started on the right path.

dragoncar

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Re: Volatility and Risk are Not the Same Thing
« Reply #13 on: November 17, 2014, 10:52:21 PM »
The purpose of my post was to get people thinking about risk before anything else.

Many investments that people own do not have daily quotes - real estate, privately held companies, collectibles, life insurance, annuities, etc. It's darn near impossible to measure the volatility of those investments. But if we can think about the risk(s) first (or margin of safety or however you want to define it), then that'll get us started on the right path.

It's a point that bears repeating once in a while.  I'm sure someone on this board has just come across this concept for the first time thanks to this thread.  Similarly, expected volatility/risk/returns are not necessarily the same as historical volatility/risk/returns.  We sometimes model portfolios using historical data because that's what we have access to, but there's nothing to say that a previously volatile asset class won't settle down in the future.