Volatility is the standard measure used by advisors to measure risk. It has been useful but has limitations. There are ways that volatility will not provide an accurate representation of the risk of an investment portfolio.
The popularity of volatility as a measure of investment risk is widely attributed to modern portfolio theory, introduced by Nobel Laureate Harry Markowitz in 1952. Markowitz’s key insight was that an investor should rationally demand higher returns to compensate for the risk of owning more volatile investments. It’s hard to believe, but prior to this, volatility of returns was seldom a consideration when assessing portfolio performance.
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As there was no standard convention for how to measure portfolio risk, Markowitz chose volatility as an appropriate metric out of convenience and practicality. The volatility of an investment or portfolio could be measured by a well-known statistical concept: the standard deviation.
Standard deviation offered several advantages that contributed to its adoption and popularity:
- It is mathematically simple to calculate and compare across individual assets and portfolios.
- It provides a simple interpretation (what range of returns are expected over any given time horizon).
- It can be easily used to estimate the likelihood of a given loss.
But standard deviation has several significant disadvantages that can lead to naive risk assessments:
- It doesn’t address all the major risks that concern a typical investor.
- It doesn’t mean what most people intuitively think it does.
- It is based on assumptions that don’t fit the real world.
Risk defined
There are a variety of definitions of investment risk, but the most appropriate one for the advisory profession is: “the chance that the investment strategy will not allow the investor to fulfil their aspirations and meet their obligations in life.” By this definition, there are many factors beyond volatility that will affect the client’s financial trajectory and outcomes.
Let’s start with the fact that risk is a one-sided concept, associated with the likelihood of negative outcomes, while volatility is a two-sided measure, treating good and bad outcomes equally. Most investors have an asymmetric view of variability, with more aversion to losses than attraction to gains. Volatility can provide estimates of the likelihood of negative outcomes, but it is more appropriate as a measure of variability than risk. Volatility doesn’t provide the client with an intuitive and practical understanding of that variability or its effects relative to their objectives.
Finally, high volatility includes the possibility of large positive outcomes that can outweigh the negatives.
Risk factors beyond volatility
Low volatility is typically associated with lower returns, which can increase the risk that a portfolio won’t generate sufficient capital growth or income to meet the client’s long-term needs. Many people approaching retirement will increase the fixed income portion of their holdings to reduce volatility, thinking they are also lowering their shortfall risk. However, in today’s low-yield environment, this could increase their shortfall. Because investors typically demand higher returns from higher volatility assets, a higher volatility position may be less likely to fall in value over longer time periods and less likely to fall short of investment targets.
A portfolio with historically low volatility may have hidden exposures to unexpected tail events caused by structural factors; for example, a popular investment style may be prone to sharp declines if many similar investors exit at the same time (also known as overcrowding).
Correlations increase in times of stress. A “low-volatility” fund can have a high-beta exposure to the market. Adding asset classes with high historical volatility can reduce risk if they are negatively correlated to the portfolio, mitigating the risk that all holdings will decline at the same time.
Finally, volatility measures don’t uncover the risks inherent in concentrated stock positions. Two portfolios may have the same volatility, but one may be considerably riskier if, for example, it contains higher exposure to individual stocks.
Read the full article here by Akhil Lodha, Advisor Perspectives.
