Finance 101 – Volatility

This is the third instalment in a series that explores a number of finance and investment concepts in both theory and in practice.‍

Chemists use the term “volatility” to describe the tendency of a liquid or solid to evaporate at a given temperature and pressure. Individuals who demonstrate unpredictable mood swings are said to have “volatile” personalities.

In the world of finance, the term “volatility” (often shortened to just “vol”) refers to the “standard deviation” of the investment’s return distribution (either historical or expected). It is the single most widely used metric to quantify an investment’s risk. The terms “standard deviation” and “volatility” are used interchangeably and are both represented by the lower-case Greek letter sigma (“σ”).

For example, we might say that an investment has a return expectation of “+10% per annum with 15% volatility”. This is a short-hand way of saying that a little more than 2/3 of the time that particular investment’s annual returns should end up in a range of  +/- 15% from a +10% midpoint (i.e. between  negative 5% and positive 25%). This also means that in slightly less than 1/3 of instances, we should expect the investment’s return to be either worse than -5% or better than +25%. The higher the “vol”, the wider the range of expected returns and the greater the investment’s risk.

The finance industry relies heavily on volatility as a risk measure, partly because the math is straightforward, but mostly because it conveniently distills risk down to a single, quantifiable variable.

At Northwood, we believe that using volatility as a measure of risk has a number of significant flaws and limitations, which make over-reliance on volatility potentially hazardous as it can provide a false sense of security.

For one, volatility doesn’t differentiate at all between upward movements and downward movements. Consider the two portfolios below:‍

Financial analysts would consider Fund B, with zero volatility, to be less risky. We don’t think investors would sleep better at night knowing they lost money every year, with very little “risk”. If you ask our clients about what risk means to them, they will usually respond with “losing money”, and Fund B appears certain to lose money.

Another issue is that volatility, as statistical measure of risk, relies on historical data and is therefore backward looking. Assessing an investment’s risk based on its past volatility is like driving with your eyes fixed on the rear-view mirror. It does not tell us much about where we are going.

A particularly troublesome problem is that the use of volatility as a measure of risk fundamentally relies upon an inherent assumption that investment returns are “normally distributed” like the smooth and symmetrical bell curve shown above.  In the real world, markets do not behave normally at all.

First, investment returns are rarely symmetrical in their distribution. They tend to be skewed to the downside (there is a higher probability of extreme negative returns than equally extreme positive returns).

Second, the occurrence of outlier returns (both positive and negative) is abnormally high. The tails of the distribution are “fatter” than they should be.  

And third, the degree of volatility in investment markets does not remain constant over time. Some time periods are much more volatile than others. (In case you are curious, these three complicating factors are formally known as “skewness”, “kurtosis”, and “heteroscedasticity”.)

Because of all these flaws and limitations, it can be especially dangerous to rely on volatility as the sole measure for assessing and managing risk. We will certainly measure and weigh volatility when evaluating our investment managers’ past performance, but it’s only one risk factor out of many.Having addressed some of the pitfalls associated with using volatility as a measure of risk, let’s look at a more useful way for families to think about and manage risk when they are focused on achieving their long term goals.  

We believe that risk means the possibility of our clients’ not having the necessary funds available to pay for their goals at the required time. It’s that simple… no Greek letters, no complex formulas, no arcane jargon. Can your goals be funded, yes or no?A sharp market decline that ultimately has no impact on your ability to fund your family’s goals isn’t really a risk. Market declines are frequent and can be intensely unpleasant, but they are always temporary. But if the overwhelming majority of your funds are invested in a particular market or investment, and it happen to crash at the very time you need to withdraw funds, then you’ve potentially put your goals at risk.

Avoiding this unfortunate situation isn’t difficult, but it does require planning (clearly identifying your goals, and anticipating the timing and cash needs for each) along with an investment approach focused on prudent diversification and liquidity management. Having a balanced mix of assets (some of which are resistant to downturns, such as cash and high quality bonds), and maintaining sufficient liquidity (so your assets can be easily converted to cash as needed) can help ensure that no matter how volatile financial markets might become, your family’s goals can always be met. In our opinion, that’s a much more practical approach to managing risk.

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