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Volatility useful gauge of risk, except when it's not

Dan Kemp  |  24 Sep 2018Text size  Decrease  Increase  |  
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Heightened volatility has a lot in common with the recent snowstorms. We know to expect them from time to time, we have a reasonable idea of what drives them, yet they still come unexpectedly and with a force that gets people talking.

In financial terms, volatility is often considered the equivalent of the beast from the east – synonymous with high risk and inclined to keep you indoors. Of course, the desire to grasp volatility is valid. If it were possible to predict, its usefulness would be almost unparalleled. We could hide from the storms and surface when the skies are clear – yet, rarely is this so easy. In fact, we’d suggest it is nearly impossible.

When we apply perspective, the desire to grasp volatility is really a desire to understand the risk of a permanent loss. These are not the same. Risk of a permanent loss is a function of valuation, fundamentals, financing and behaviour--which are worth measuring.

Volatility is different

A fear-driven headline is persuasive – “volatility has spiked”, “the VIX hits its highest level in 10 years”, “panic selling causes volatility to rise”. Yet, conceptually, the relationship between volatility and risk remains a bit of a misnomer.

When making investment decisions, many investors confuse uncertainty (an unknown distribution of returns) and risk (a certain distribution). This plays an important role in risk management, as it tends to result in investors becoming overconfident when they use historical analytics as a precursor to future outcomes. So, in this context, how does one go about building a systematic process to manage risk?

The industry standard has become known as volatility--a concept that is popular with participants due in part to its simplicity.

What is volatility trying to achieve? In a portfolio management sense, volatility is typically used to help understand downside risk, which is generally bound to one of two problems: 

  • Experiencing a permanent loss of capital in an investment that is not recoverable in an investors’ timeframe.
  • Behavioural reactions that cause one to crystalise a temporary loss, thereby making it permanent when it was otherwise recoverable.

Time horizon

Before delving into volatility and its usefulness, a vital part of this is to consider the impact various investment horizons have on risk management. Downside risk (and volatility to some extent) has a greater relevance over shorter time periods, as it can result in a permanent loss of capital. For example, below we illustrate the relationship between drawdowns and volatility over a rolling five-year timeframe (using the S&P 500 since 1900), showing the sensitivity to a short timeframe. 

Volatility helps an investor loosely understand the range of outcomes that may be expected from an asset, such as the inherent risk between equities and other assets (such as cash or bonds) and may even be useful in building an asset allocation with a risk tolerance level in mind. However, to truly understand risk and build asset allocations holistically, the imperfections of volatility are worth investigating. For example, what are the in-built assumptions? Is portfolio risk sensitive to valuations? And could there be a better way to assess risk?

This is an area that Morningstar has explored in detail, addressing limitations to the use of volatility as a measure of risk.

Themes, history and behaviour

Morningstar also looks at the utility, and limitations, of historical estimation. This is viewed as useful for understanding risk in perspective, but investors need to remember it fails to account for structural change in an asset class.

For example, the different country exposures in emerging market) and those vulnerable to leverage. This is most notable in fast-shifting landscapes, but is also time dependant – for instance, the US equity market was dominated by rail companies 100 years ago, so may have little bearing on the tech giants today.

Within this, the key is to focus on the long term but build in a margin of safety that reflects the uncertainty. Rather than focus on short-term measures such as the VIX, which is a 30-day implied volatility measure, we would suggest looking at 10- or even 50-year measures of risk and adopting a margin of safety that reflects the potential for structural change in an asset class.

The investor behavioural aspects relevant to the use--and misuse--of volatility are also considered. In attempting to quantify risk, many investors subject themselves to behavioural deficiencies such as loss aversion, the recency bias and overconfidence. These biases can ultimately lead to irrational assessments of risk to the detriment of portfolio outcomes.

Ultimately, we find that there are no silver bullets when it comes to risk management. Yes, some metrics are better than others. And yes, focusing on drawdown metrics rather than volatility could improve the likelihood of success. However, a successful risk management process comes from the discipline of understanding what is knowable and what is not.

Rather than over-emphasising volatility, or any other quantitative measure, one of the best ways to control for risk is to buy fundamentally strong investments that are attractively valued. Beyond that, sound risk management is about being aware of the behavioural pitfalls that underpin decision making and building a framework that helps us overcome these challenges.

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Dan Kemp is chief investment officer, EMEA, Morningstar Investment Management.

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