A while back I wrote an article that examined an interview given by Warren Buffett (Trades, Portfolio) in which he opined that volatility is not the same as risk. He was primarily concerned that volatility is a source of opportunity, as mismatches between prices and value are what value investors thrive on. This is certainly true, although, as was helpfully pointed out, volatility is risk if you are short volatility itself, as in a long-short position, or by being short a product like the VIX.
However, there is another way in which risk and volatility diverge, and that is when investors mistakenly assume that low volatility is synonymous with low risk. For Howard Marks (Trades, Portfolio), risk is not volatility. Risk is the probability of capital loss. In 2006, he authored an excellent memo that explained why the two terms are confused.
Not everything that can be measured should be used
Marks believes that volatility started being used as a proxy for risk because volatility can be quite easily measured, and therefore lends itself very well to statistical modelling.
“According to the academicians who developed capital market theory, risk equals volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition of risk. It’s my view that — knowingly or unknowingly — academicians settled on volatility as a proxy for risk as a matter of convenience. They needed a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risk do not. The problem with all of this, however, is that I just don’t think volatility is the risk most investors care about.”
Conversely, risk is incredibly hard to calculate, particularly when it comes to "fat tail" events -- events with uncertain probabilities, but significant impacts. Most investors have a natural aversion to things that cannot be assigned a precise numerical value, as doing so seems speculative and unrigorous. But it is much better to be approximately right than precisely wrong. By using increasingly complicated models in our investing we risk mistaking the map for the territory.
You already know what real risk looks like
Another point made by Marks is that most people actually have an intuitive understanding of the true nature of risk:
“There are many kinds of risk. But volatility may be the least relevant of them all. Theory says investors demand more return from investments that are more volatile. But for the market to set the prices for investments such that more volatile investments will appear likely to produce higher returns, there have to be people demanding that relationship, and I haven’t met them yet. I’ve never heard anyone at Oaktree — or anywhere else, for that matter — say, 'I won’t buy it, because its price might show big fluctuations,' or 'I won’t buy it, because it might have a down quarter.' Thus, it’s hard for me to believe volatility is the risk investors factor in when setting prices and prospective returns.
Rather than volatility, I think people decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return. To me, 'I need more upside potential because I’m afraid I could lose money' makes an awful lot more sense than 'I need more upside potential because I’m afraid the price may fluctuate.' No, I’m sure 'risk' is — first and foremost — the likelihood of losing money."
Real risk management is not a question of smart statistical analysis. It comes only from a deep understanding of the fundamentals of the underlying assets, and of the business conditions that surround them.
Disclosure: The author owns no stocks mentioned.
Read more here:Ă‚
Warren Buffett: What Makes a Good Moat and What Does NotÂ
Morgan Stanley’s Business Conditions Index Hits 2nd-Lowest Reading EverÂ
David Einhorn: How to Manage Investment RiskÂ
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