Is risk synonymous with volatility? When an investor wants to understand risk, must he look at volatility?
The term risk has different meanings for different people.
Ask an investor what comes to mind when talking about risk management, he will state that he does not wish to lose his money, or will want to know as to how much the return can potentially drop by.
Throw the same query to a finance professional and he will tell you that standard deviation is the measure of risk. So what he is saying is that risk is not defined as the likelihood of loss, but as volatility, which is determined using statistical measures of variance such as standard deviation and beta.
(Standard deviation is a measure of absolute volatility that shows how much an investment’s return varies from its average return over time. Beta is a measure of relative volatility that indicates the price variance of an investment compared to the market as a whole. The higher the standard deviation or beta, the higher the risk.)
So while professionals often use volatility as a proxy for risk, it does not measure what an investor intuitively perceives as risk.
It is more helpful to think of volatility as sudden price movements. Volatility encompasses the changes in the price of a security, a portfolio, or a market segment both on the upside and down. So it’s possible to have an investment with a lot of volatility that is moving one way: up (not always down).
Even more important, volatility refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period—a day, a few weeks, a month, even a year. Such fluctuations are inevitable and come with the territory. If you are in for the long haul, volatility is not a problem and can even be your friend, enabling you to buy more of a security when it’s at a low ebb.
The most intuitive definition of risk, by contrast, is the chance that you will lose your principal investment and won’t be able to meet your financial goals and obligations. Or that you will have to recalibrate your goals because your investment kitty comes up short.
Having said that, it is easy to see how the two terms have become conflated. If you have a short-term horizon and you’re in a volatile investment like stocks, it could be downright risky for you. That’s because there is a real risk that you could have to sell out and realise a loss when your investment is at a low ebb.
The same investment with a long-term horizon throws up a completely different scenario. The very same stocks may not be all that risky if you bought them at bargain rates when compared to their intrinsic value and intend holding on to them for many years. However, you will have to contend with volatility which comes with the territory.
In 2008, the global crisis drove securities prices to especially low levels actually making them less risky investments. Indeed, Seth Klarman, one of the world’s most respected value investors, believes that risk is not inherent in an investment, it is always relative to the price paid. So in the midst of volatility and extreme uncertainty of 2008, the risk of investing in equity actually dropped.
Reactions to volatility are very often emotional. Investors buy and sell on reaction, or rather overreaction, to news and speculation without any significant consideration to long-term returns. Recall the sell-off of not just 2008 but even 2011 when volatility went through the roof. Now look at where the market is today. The volatility did not really affect the long-term returns of an investor who assesses risk in terms of long-term failure to meet a pre-determined outcome. Those who ignored the volatility and stayed are better off because of it.
Given this backdrop, defining risk as volatility runs counter to common sense. Do not assess risk and construct your portfolio based on the volatility of the ride. Investment risk is the possibility of suffering losses and its potential magnitude. Another indication of investment risk is the maximum drawdown from a previous high – peak to trough.
So how can investors focus on risk while putting volatility in its place? Come to terms with the fact that volatility is inevitable and if you have a long enough time horizon, you will be able to harness it for your own benefit. Secondly, invest in equity mutual funds via a systematic investment plan, or SIP, to ensure that you are entering the stock market in a variety of environments, whether its feels good or not. Finally, diversifying your portfolio among different asset classes and investment styles can also go a long way toward muting the volatility of an investment that’s volatile on a stand-alone basis.
These moves will make your portfolio less volatile and easier to live with.
