Volatility vs Risk

Much has been written on this topic, but for what it’s worth, here is my take.

Volatility is how much something moves up and down. The stock market is more volatile than the bond market, on average. Yet, a black-box hedge fund might be less volatile than S&P500, but is it less risky?

Risk = Unexpected Outcomes + Unrecoverable Consequences

In my view, Risk is an unexpected outcome that produces unrecoverable consequences by making investors abandon what they are doing and switch to something else. Risk causes action while Volatility just emotion. Risk sends investments on a new, previously unplanned for trajectory, which is usually much worse than the original path. Risk is when you wish you could go back in time and do it all over again, while Volatility is normal uncertainty of future outcomes.

“That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.” - Warren Buffett 2014 Annual Letter

There are two investment outcomes that can manifest as either Risk or Volatility depending on whether the investor's investment process expected them or not: low average returns and large crashes (see a detailed blog here)

Unexpected Outcomes = Large Crashes + Low Returns

For the diversified asset classes with the help of long-run history (see GFD data), we can have a good understanding of asset’s possible investment outcomes. We can set our expectations to include the large periodic crashes and occasional long stretches of low returns. Once within our expectations and the investment process, they are no longer risky, just volatile. Visualizing the full distribution of outcomes converts risk into volatility, making it much less damaging and more controllable. If you expect the occasional S&P500 crash (such as -84% drawdown on June 1932 ), or any individual country equity wipe-out (think Germany (1920’s), Russia (1910’s), China (1920’s)), then these negative outcomes are just volatility and not risk because your approach will remain the same during these episodes.

The low returns outcome is less dramatic than the crash, but non-the-less can be as damaging over the long run if the investor is unprepared for it.

“We should note that standard deviation doesn’t capture the most important risk, which is that the return will be bad. That is because standard deviation is an approximate expression of the volatility around a return number, so it doesn’t capture the risk that the expected return number will be wrong and bad. When thinking about risk, please think about both the volatility risk and the risk that our assumptions are wrong.” – Ray Dalio

Of course, the challenge becomes creating such a resilient approach that can handle extreme crashes and low returns. The other alternative is to ignore history, adopt a belief that what happened a hundred years ago will never repeat in the future, and then hope you are right. (As my old boss likes to say: “Hope is not an investment strategy”). The third option is to ‘wing it’, which is what sophisticated investors seem to be doing the most: they acknowledge that they can’t be 100% certain that some major asset classes will never crash like it had done historically, but because they don’t think anything can be done about it ex-ante, they keep on investing like it’s not going to happen. And maybe it won’t happen on their watch, or if it does, it will be happening to everyone else as well, so the pain will be easier when experienced with peers.

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“The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome.” - Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk

Given the importance of this problem, I would suggest that the following question be a priority: How should investors build asset allocation portfolios that are resilient to great depressions, world wars, hyper-inflation, equity bubbles, and low-expected returns? What are the possible ways to combine the diversified asset classes into portfolios that will capture the upside while reducing the drawdowns? With so much intellectual power in most universities and all their innovations in forecasting, portfolio construction, and risk measurements it would be most insightful to have a unified portfolio from each university that incorporates their best research.

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Just like asset classes, investment strategies come with their own profile of volatility and risk. Some strategies might be more volatile than others, but because of their transparent and reliable historical return distribution be less risky over the long-run. For example, my co-author and I have documented a very long-run history of Value and Momentum strategies across major asset classes (for example, see here and a lot more here), which includes crashes and long periods of under-performance. Just like with traditional asset classes, this history helps visualize the potential outcomes of these strategies making them more expected and hence less risky (example here).

The quant meltdown of August 2007 was Volatility to some and Risk to others. Strategies that had high leverage or low future alpha potential of their models, never recovered from this event, such as the largest quant fund of the time. Unfortunately, they faced the risk side of the meltdown. Others, with better factor diversification and lower tracking errors, bounced right back and continued performing, some even better than before, perhaps because of the reduced competition.

Ten years later, in August 2017, an Institutional Investor article wisely focused on the question of whether another quant meltdown was about to repeat because of skyrocketing popularity of quant investing. Since then, 2018 and 2019 have been very hard on many quant / factor investors, and Cliff Asness, just called the current environment a “Crappy Time for Factor Investing”.

This time again will test the investment processes of quants and their clients as they decide if this is Risk (time to change), or just Volatility (expected, yet unpleasant).

“Everything that’s alive likes some variability …it’s better to fail early – and moderately – than to fail late, and catastrophically…the distinction between risk and volatility, is that a lack of volatility is risky as it means being unprepared for extreme events.” - Nassim Taleb (adapted from here)

“Academics have espoused nuanced permutations of their flawed theories for several decades. Countless thousands of their students have been taught that security analysis is worthless, that risk is the same as volatility, and that investors must avoid overconcentration in good ideas (because in efficient markets there can be no good ideas) and thus diversify into mediocre or bad ones. Of course, for value investors, the propagation of these academic theories has been deeply gratifying: the brainwashing of generations of young investors produces the very inefficiencies that savvy stock pickers can exploit.” Seth Klarman, Introduction to Security Analysis 6th edition by Benjamin Graham

PS. Thank you Mike Fernandez for helping with this post.