When it comes to investing, many people associate volatility with risk. In fact, most freely substitute the two words interchangeably. This has led most of the financial industry to reference an investment’s volatility when talking about risk. However, Corey Hoffstein made a good point in a recent article regarding risk.
“In and of itself, price variability is not the manifestation of riskiness, but rather a signal of uncertainty. Volatility is an indication that the market is having difficulty reaching a consensus on a forecast of future events, their probabilities, and their impacts.”
I tend to agree with Corey on this point. Volatility statistically measures the dispersion of returns an investment has seen over time. People tend to associate a larger dispersion of results with greater risk, but is that always the case? Again, I’d agree with Corey’s assertion that it more measures uncertainty. Uncertainty does not always equal risk, even if uncertainty seems scary.
Is volatility a proper surrogate for risk? Javier Estrada wrote an excellent paper titled, “Rethinking Risk”, that answers this question.
“Investors that focus on uncertainty are likely to view stocks as riskier than bonds, and those that focus on long-term terminal wealth are likely to view stocks as less risky than bonds even if they are concerned with tail risks.”
Is it really risk that investors fear or is it uncertainty? They’re similar, but they don’t necessarily mean the same thing. Kind of like risk and volatility. Over long term time horizons, stocks tend to outperform bonds. However, stocks are scary to some investors because the dispersion of their results has also been greater. Daily fluctuation in stock prices is something that some people just cannot deal with mentally. Bonds may have a lower dispersion of results, but they probably won’t keep up with stocks if you’re investing for something like retirement that’s 30 years off in the future. I’m not saying volatility and risk are uncorrelated, but let’s stop using the two interchangeably.
Sources:
http://www.indexologyblog.com/2014/10/07/what-is-risk-anyway/
http://www.etftrends.com/2014/10/indexology-what-is-risk-anyway/
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2318961
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