What is almost 100% of rational investors afraid of? It’s the possibility that they’ll lose money on the investment that they’re thinking of buying! Volatility, or the standard deviation of stock returns in a given interval (say 5 minutes, daily, weekly, etc.), is the default measure of risk unquestionably used by the Finance departments at universities and Financial news like CNBC and the WSJ. But while the instability from volatility in a portfolio is often disconcerting, the ultimate fate that virtually every investor wants to avoid is losing money. Unfortunately, although volatility is easier for academics and analysts to work with, it’s too narrow of a definition of risk in the real world.
#1: Volatility is an objective measure. Risk is subjective
One of the most common colloquial definitions of risk I’ve heard among those that reject volatility as the definition is: “the probability of losing money.” While that’s a good start, it’s too broad for my tastes, and besides, it’s very rare to buy a stock and have it stay in the green the entire time, due to the sheer random fluctuations of the stock market. Still, very few of you would likely raise an eyebrow if you bought a stock for $40.25 and checked the price again 10 minutes later and it’s trading at $40.20 even though each share had lost 5 cents. On the other hand, it if were trading at $35.50 10 minutes later, you’d not likely be happy with the trade.
I’d like to think of the common sense definition of risk as the probability that an investment will incur an unacceptably large loss. That unacceptably large loss is what I like to think of as your loss threshold (and I highly recommend all investors and traders determine this amount before entering a trade.) By definition, this amount is subjective for everyone and depends on both your life circumstances (particularly your age), your financial situation, and your psychological tolerance for loss. Volatility, on the other hand, is objective and relatively easy to measure even though there are a plethora of different benchmarks besides standard deviation like Average True Range (ATR). In other words, volatility is measured the same for everyone as long as a standard formula is agreed upon but the same cannot be said of risk.
#2: Volatility is backward looking; risk is forward looking
Volatility requires multiple data points in the recent past before it can be meaningfully calculated so it’s a backward looking measure, again, by definition. Risk is only concerned with the probability of losing a lot of money in the future, not how much money that investment has cause investors to lose in the recent past, as measured by volatility.
#3: High volatility usually implies at least somewhat high risk, but low volatility doesn’t necessarily imply low risk.
When most traders say a stock or security is “too volatile” what they actually mean is that the security has exhibited large price swings in the recent past (and hence has a large standard deviation) and those large price swings are likely to persist in the future. This is plausible in most cases as higher than normal volatility usually subsides gradually. But the opposite can’t be said of a low volatility stock: small price fluctuations in the past don’t imply that price fluctuations will be small in the future. Black swan events could easily hit a low volatility stock and shock it into having large price swings without any warning.
#4: Volatility concerns both the upside and downside; Risk only concerns the downside.
It makes no sense to use a risk measurement that penalizes an investment for making too much money, right? But that’s what you’re doing if you use volatility to measure risk! Most traditional measures of volatility like standard deviation and ATR don’t distinguish between price fluctuations on the upside and the downside. It’s a bit understandable because not only will excluding upside volatility make the math more complicated but most securities that have high upside volatility will often be met by high downside volatility some time in the future (when traders start taking some profits) though the converse isn’t always true (since plenty of companies have been afflicted with high downside volatility shortly before their stock went to zero.)
#5: If you want high returns, high volatility is mandatory. High risk isn’t.
You may have the heard centuries old saying that “the more money you want to make in the markets, the more risk you gotta be willing to take.” I think this way of thinking is a bit misleading. As Oaktree’s Howard puts it, “if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier. Misplaced reliance on the benefits of risk bearing has led investors to some very unpleasant surprises.” Now, here’s where it pays to know the difference between risk and volatility. If you want to make a ton of money investing or trading, low volatility securities are not going to get you there because their prices don’t fluctuate very much. So this leaves high volatility securities.
If you’re a long-term investor seeking high returns, you will need to willing to take somewhat high risks. Why? Securities capable of exhibiting high returns have high volatility and virtually none of them follow a straight-forward and smooth trajectory upwards. There will be many corrections and false starts along the way even if you’re lucky enough to pick the next Microsoft or Google. On the other hand, as a trader, you can reduce some of that risk even in a high volatility environment by using a momentum strategy on a micro level and setting tighter stop losses although you’ll be facing higher financial and psychological costs due to higher commissions and decision fatigue.
I like to think of the risk in any security as divided into 2 components: the Apparent Risk and the Unapparent Risk. Total Risk = Apparent Risk + Unapparent Risk. The Apparent Risk is readily visible to the eyes in the form of recent volatility. The Unapparent Risk is the danger lurking in the future that has yet to manifest itself as volatility (aka a black swan.) Volatility can often be a symptom of risk but sometimes risk has no symptoms. It’s important to do an in-depth analysis of all of the reasonably conceivable ways an investment can lose significant value in the future rather than perform a superficial analysis on its volatility in order to fully assess its risk.