Volatility is not Risk

At a Pension Fund industry conference last week, I saw a rather small diversity in quality of presentation but a large diversity in quality of content.  Every speaker was polished and held the audiences’ attention (good!) but about half of the presentations were, well, void of real content.  This is an ongoing problem in most industries — pundits are chosen not because their content has passed some independent tests but rather because the speaker has risen to prominence in his/her field and is therefore considered “an authority.”  Pardon my bluntness, but appeals to authority are not exactly the hallmark of critical thinking or knowledge transfer.  In this case, several of the speakers referred to risk as equivalent, or at least reasonably measured by, volatility.  Ugh.  I made a very clear statement when it was my turn at the microphone: “Volatility is not Risk.  Volatility is what happens every day.  Risk is what ends my career.”  For effect, I even stopped and said “it’s worth repeating slowly.  V-o-l-a-t-i-l-i-t-y    i-s    n-o-t    R-i-s-k.

In many parts of the financial services industry, volatility has been associated with risk for so long that it’s simply ingrained in the vocabulary.  I make a point in many of my presentations of explaining the overuse and misinterpretation of beta, which is nothing more than a scaling of volatility (when you have a sufficiently highly correlated benchmark).  The mutual fund industry strictly uses beta (and hence volatility) as a measure of risk – just log into your fidelity, vanguard, or schwab account and look at the prospectus of any fund.  The risk section will give you two numbers: beta and R-square.  Given that Pension funds invested primarily in mutual funds, it should come as no surprise that the Pension Fund industry followed suit – using beta (and therefore volatility) as a measure of risk.

While it’s true that funds with higher volatility are considered “riskier” than funds with lower volatility, the point is that volatility is inherently a measure of what happens on typical days.  It is a measure of the width of the return distribution.  In other words, it measures how much returns typically swing.  Sure, putting your money into a fund that has a low volatility makes it more likely that you won’t suffer a big loss most of the time as compared to a fund with a higher volatility, but the important thing to keep in mind is that real risk is what happens once in a decade or ‘out of the blue’ and has a profound impact on the fund.  It’s not what happens “most of the time.”  And beta/volatility tell you nothing about these outliers.

Even worse than using beta/volatility as a measure of risk is the practice of using ‘Tracking Error,” which measures how closely the fund’s returns follow some benchmark’s returns.  Tracking Error is considered a measure of risk by the mutual fund and pension fund industries.  Low values of tracking error are meant to indicate low risk.  But this measure has nothing to do with how much money a fund can lose.  Nothing.  What it does accomplish is measuring how closely the fund follows a chosen benchmark.  Now suppose that benchmark tanks, like the S&P (a very common benchmark) did during the financial crisis.  Having a low TE (interpreted as low risk) ensured that your fund loses as much as the benchmark does – about 45% in the case of the S&P in 2008.  How is that low risk?!?

I’m beginning to think that rather than trying to explain why beta and tracking error are not measures of risk, maybe it’s just better for me to have the audience take a deep breath and repeat after me:

  1. V-o-l-a-t-i-l-i-t-y    i-s    n-o-t    R-i-s-k.
  2. V-o-l-a-t-i-l-i-t-y    i-s    n-o-t    R-i-s-k.
  3. V-o-l-a-t-i-l-i-t-y    i-s    n-o-t    R-i-s-k.

There.  Doesn’t that feel good?

3 Responses to Volatility is not Risk

  1. This is an interesting post and I agree with you in many respects. I too see a lot of this “but about half of the presentations were, well, void of real content” Such is life and mediocrity is a norm even in the speaker circuit, sadly.

    On volatility, Volatility is intertwined with risk but I agree with you it isn’t risk.

    If you are investing in an option free asset volatility increases the zone or breadth of unknowable outcome and the risk. If on the other hand you are chasing payouts based around it, then volatility itself may be what you are desiring rather than trying to avoid.

    When you are long volatility by writing options or butterflies, the absence of it will be to your winning advantage but a symmetrical reverse position would have the investor desiring as much volatility as the market can give.

    I fair its all in your appetite for taking on PnL gamma. So I agree Volatility is not risk by itself, it all depends on your proximity to the volatility surface, that is where risk is found or avoided. The issue I find brings us full circle, mediocre analysts just focus on volatility not their gamma appetite for it.

    • Martin — thanks for the comments. I wasn’t even thinking about gamma risk when I wrote this – I was just thinking that many people confuse a “high vol” fund as the definition of “high risk” and they’re not thinking at all about any tails, whether generated through outright or implied optionality. By thinking about it in terms of options, you’re highlighting the point quite nicely: that high vol can be turned into low risk with the right option play just as low vol can be made risky with the appropriate optionality. Nice way to think about it!

  2. Pingback: Volatility is not Risk | Revolusionline

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