Is It Smart for Investors to Equate Risk and Volatility?Sheaff Briefs Editor
Value means different things to different people. Therefore risk (the possibility of losing something of value) can also mean different things. For decades, investors defined risk as the chance of permanent loss of capital. Wherever there was volatility in the price of an investment, that meant there was risk. But are risk and volatility really the same?
As Sheaff Brock Director Jim Murphy explains, understanding the difference between market volatility and market risk is a key skill for investors to have. Volatility is how rapidly or severely the price of an investment may change, while risk is the probability that an investment will result in permanent loss of capital.
In the early 1950s, after Harry Markowitz had introduced his Modern Portfolio Theory, the concept of risk avoidance gained great influence in the world of portfolio management. Computer programs came into being to plot different investment mixes into an “efficient frontier,” causing many financial professionals to equate risk and volatility.
But according to more modern thinking, volatility and risk are two very different things. By 1990, Michael Keppler was stating in the banking industry journal Die Bank that modern portfolio theorists do not define risk as a likelihood of loss, but as volatility, which is determined using statistical measures of variance. (Keppler, then First VP of Commerzbank Capital Markets in New York, viewed Modern Portfolio Theory with concern, questioning the use of volatility as a proxy for risk.) Standard deviation, Keppler explained, measures how much any investment’s return varies from its average return over time. Beta, meanwhile, is used to measure the price variance of an investment compared to the market as a whole.
The point Keppler stressed is that “volatility, in other words, is essentially a double-edged sword, and does not measure what an investor intuitively perceives as risk.” In a rising market, Keppler emphasized, high volatility can boost the return potential of an investment!
In 2007, Goldman Sachs went even further, determining that index volatility should be considered an asset class in itself, offering diversification and the possibility of investment return.
In Sheaff Brock’s thinking, investors put themselves at a disadvantage by equating risk and volatility. If investors choose to do all they can to avoid both risk and volatility, they will typically pay some price through lower returns. Alternately, they can differentiate between the two, adopting strategies that may prudently profit from volatility.