Risk VS Volatility
Stupid question:
My understanding is that risk/volatility are measured as the same thing - the s.d of returns. Why is this the case?
Surely at better (albheit harder to quantify measure) is the probability of an asset going up?
Take for example the S&P, which is considered fairly risky with a sharpe of about 1. Despite this (and the big drawdowns) the risk of being down over a 10-20 year period is incredibly low, making it a ridiculously low risk investment. Furthermore, any black swan events that may occur are not predicated by ‘variational’ risk. In this sense, surely no matter the outcome, the variation is not a good measure of risk?
Howard Marks describes risk as “first and foremost the probability of losing money”, rather than std of returns. And Taleb describes a notion of risk that is more qualitative than quantitative.
And yeah, I agree with your post. Equally i do not understand why standard deviation of returns is synonymous with “risk”. In my mind, it just does not make sense to lazily refer to this as “risk” and is confusing if anything. Would be way clearer to refer to “volatility adjusted returns” as that is literally what it is.
Something can be “risky” without being volatile and vice versa.
That is why I find the Sharpe ratio flawed. Historical volatility can just be the market misunderstanding a business.
Imagine an unhedged single long investment. I agree w/ your view that the real probability of losing money is the ‘true risk’. How will we estimate it for risk management purposes? What’s the risk the thesis is incorrect? Well I guess the easiest place to start is on earnings, then multiple. How will we estimate the earnings….. ooops now we’re doing an analysts job. But ok, we’ve got a solid probability weighted upside / downside. Are we sure the downside is correct? How big should we make (it for how sure we are)? Also - what’s the risk that the currency / regulations / macro go against us? What’s the risk it gets meme’d to +4000%?
Now take a group of stocks - and let's assume you’ve got a perfectly accurate probability weighted upside / downside case. But wait - are these all dependent on oil or interest rates or some sector thesis? If so we can’t lever very much, they could all go bad at once right?
Now imagine we have to assign monkeys with darts to do all of the above for us, but only 1/10 monkeys will actually be kinda good. Also the good monkeys may become reckless or greedy. They may REALLY think oil is going up - and just YOLO all your money on a long oil bet that merely LOOKS diversified.
Let’s start by removing that last step about the sizing smaller due to covariance between FUNDAMENTAL outcome. Well, I don’t wanna go thru each of the monkeys models, so I’ll estimate covariance to handful of 'factors' as a heuristic - and make sure the monkeys are only betting on specifically their thesis - not gambling. We’ll pair by industry too - there - we’ve mostly removed the fundamental exposure to most things other than relative earnings/multiple.
But now the monkeys are sad, cause they can’t get rich cause all the money is mostly canceling itself out. It's much easier to yolo tech or oil than to actually generate idiosyncratic alpha. So we just lever up a lot so the monkeys can still get rich, but we need to be extra sure the monkeys don't lose too much all at once. We’ll just hire and fire the monkeys after they lose a little. I don’t have time to watch 100 monkeys and go through all their models and investments. So volatility limits will do - some of the monkeys will make money, none of the monkeys will ruin my levered monkey farm with their stupid monkey behavior.
Volatility - it’s the risk one stupid monkey Fs up my levered monkey farm. It’s useful for reducing the risk of my monkey business. If I knew which monkey was the good monkey and I had permanent capital, I’d just let the monkey concentrate in best ideas with a lockup - but then we saw what happened at the end of ZIRP when we let the tigers, I mean monkeys, do that. Most showed you the ‘permanent loss of capital’ evaluation of risk wasn’t so reliable from the LP standpoint.
Basically some businesses / portfolios just run better if you treat them as if they’re normally randomly distributed - even though they may not be
Fantastic explanation
I think the idea is that its standard deviation is obviously imperfect, but its a tool in the toolkit and its relatively easy to measure, hence a reasonable benchmark (from which subjective deviations may be made). A portfolio manager may have in their own head what the true 'risk' of a book is, but how is the firm supposed to quantify systematically what the 'risk' of every book is, and risk manage around that? Poll 10 people for their subjective opinions on every set of positions?
The best explanation I have come across that justifies using volatility as a proxy for risk is that volatility is empirically asymmetric. Meaning, markets take the stairs up and the elevator down.
Your comment “the risk of being down over a 10-20 year period is incredibly low” assumes 0 unexpected need for liquidity. As professionals managing the capital of others, you’re going to have a hard time with the sales pitch “just give me your money for 20 years and I probably won’t lose any”. On a long enough timeline we’re all dead. The risk of higher vol is that there is a chance you will need liquidity during a drawdown, and that is how you permanently impair compounding and turn vol into real risk. This is something we also have no real control over managing the capital of others, and the redemptions don’t tend to come when you are crushing it
As with most statistical measures, there is no perfect answer, and risk is one of the more nebulous concepts in finance. Ask 10 different people how they view risk and you’ll likely get 10 different answers. I’ve personally written things like volatility is not risk in the past, but as I have become more seasoned, I’ve started to pay attention to it more. I think of it as a starting point for how much return I’ll need to break even on a risk-adjusted basis, i.e. whether the juice is worth the squeeze. I’ve found that paying more attention to vol has helped kept me out of trouble and in retrospect my worst ideas have almost universally all had high trailing vol
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