There is more risk than just volatility (and a board game). Photo by Robert Nickelsberg/Getty Images.
Risk. This four letter word both tempts and terrifies investors. Some folks think it’s the ticket to sky-high returns. Others find it scary or uncomfortable. Both mentalities lead many to an effort to measure it. Because if you can quantify something (e.g. this stock is risky based on this metric), you can understand what you’re dealing with—and understanding things is nice. Don’t want much risk? Avoid the thing with the higher risk number! But as one stellar paper we recently read thoroughly explained, you can’t reduce investment risk to a single number or set of figures. Most investment risks aren’t actually quantifiable. Believing they are can lead to truly risky portfolio decisions.
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When quantifying “risk,” many folks confuse volatility with risk. These aren’t synonymous. Volatility—price movement down and up—can be tracked, measured and plotted relative to an index. Short-term volatility reminds us of the risk of loss that comes with an asset, but it doesn’t quantify risk. Measures like standard deviation, beta and the Sharpe Ratio[i] tell you how much something moved (note: past tense) relative to the market—backward-looking descriptions of price movement, not very helpful in assessing future volatility or performance. They are not permanent attributes of a strategy, security, fund, manager, tactic or squirrel. (Just kidding. Beta may be a permanent attribute of squirrels.) They do not necessarily differentiate between more and less risky strategies—especially without understanding why those figures might be higher or lower.
Now, we aren’t saying volatility isn’t a risk. It is. But as legendary investor Benjamin Graham put it:
“The idea of risk is often extended to apply to a possible decline in the price of a security, even though the decline may be of a cyclical and temporary nature and even though the holder is unlikely to be forced to sell at such times … we believe that what is here involved is not a true risk in the useful sense of the term.” [ii]
So true! Short-term decline isn’t the only risk investors face—and given its temporary nature, it may not be most important. On the extreme end, the risk of absolute or total loss—your portfolio going zero—underlies many folks’ investing jitters. While not probable, every security, whether stock, bond, commodity, mutual fund, ETF or whatever, carries the possibility you could lose the entire value of your investment. The risk of permanent loss looms, too. A security’s price could fall and, for whatever fundamental reason, never fully rebound. Investors can also self-inflict permanent loss by selling out during sharp negative volatility (e.g., during a correction), locking in otherwise temporary losses.
Opportunity cost is another risk. Maybe you have a high fixed income allocation despite your growth goals and long time horizon because you don’t like volatility. Or perhaps you’re sitting on cash, waiting for the perfect time to jump in (after that correction the media keeps talking about). These decisions may feel good or smart in the short run, but missing significant upside in bull markets may mean your portfolio comes up short of your goals and needs in the long run. The reason investing in markets works—the way your principal morphs into a much bigger kitty for use later—is compound growth. Growth cannot compound effectively if you don’t achieve it, especially early in the journey to your financial goals.
By no means is this an exhaustive list of investment risks—nor is it intended to be. But considering only risks quantifiable with metrics opens the door to other risks (like not reaching your investment goals). Selecting a strategy, for example, with lower risk “metrics” might seem correct. And it may be! But numbers without context can give an illusion of safety and decreased risk, when all you might be doing is swapping—less volatility in exchange for a reduced likelihood your portfolio lasts your life. That’s one risk for another, not more or less risk. No numerical gauge can possibly pinpoint the 100% ideal approach for your individual situation. There are always tradeoffs—crucial to understand in employing any investment strategy. (Though some commonly suggest otherwise, peddling products promising growth and capital preservation—the impossible.)
Equating risk with volatility and only volatility—as most metric-driven assessments do—does investors a disservice. Markets can be volatile and scary—especially in the short term—and nothing about investing is easy. But risk means a whole lot more than just volatility, and volatility may not reflect risks most pertinent to your personal situation.
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[i] The Sharpe Ratio actually takes this one step further, comparing standard deviation and returns, suggesting the former equates to “risk.”
[ii] The Intelligent Investor by Benjamin Graham. Published by HarperCollins. Page 121.