How To “Measure” Risk, does the volatility matter?
I’m solidly convinced the future isn’t knowable. I side with John Kenneth Galbraith who said, “We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.”
Following on with Charlie’s idea, thinking risk control is easy is perhaps the greatest trap in investing, since excessive confidence that they have risk under control can make investors do very risky things.
I argued against the purported identity between volatility and risk. Volatility is the academic’s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in the calculations and models of modern finance theory. In the book I called it “machinable,” and there is no substitute for the purposes of the calculations.
However, while volatility is quantifiable and machinable – and can be an indicator or symptom of riskiness and even a specific form of risk – I think it falls far short as “the” definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, “The prospective return isn’t high enough to warrant bearing all that volatility.” What they fear is the possibility of permanent loss.
Permanent loss is very different from volatility or fluctuation. A downward fluctuation – which by definition is temporary – doesn’t present a big problem if the investor is able to hold on and come out the other side. A permanent loss – from which there won’t be a rebound – can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing – whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but we never get a chance to undo a permanent loss.
Of course, the problem with defining risk as the possibility of permanent loss is that it lacks the very thing volatility offers: quantifiability. The probability of loss is no more measurable than the probability of rain. It can be modeled, and it can be estimated (and by experts pretty well), but it cannot be known.