Never confuse risk and volatility in investing
Instead of reaping huge rewards, investors may end up with lower returns or even permanent loss of capital if they ignore fundamentals
Of the many lazy and dangerous ways of thinking about investment, these two rank near the top: that risk equates with volatility and that risk and rewards are a straight trade-off.
Both are overly simplistic and both lie at the heart of some of the most colossal errors in recent finance. And while both contain large amounts of truth at their core, both concepts represent shorthand versions of reality rather than tools that always, or even usually, work.
In financial theory, volatility is used more or less interchangeably with risk, something hedge fund giant Howard Marks argues is mostly because volatility can be reduced to a number. That is useful when you are trying to write an equation, publish a paper or defend a thesis, but amounts to a vast over-simplification, one that threatens to put investors on a kind of auto pilot.
"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," Marks wrote in a note.
"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."
Now volatility, to be sure, can cause permanent loss because it can put investors in a situation where they choose, or are forced, to crystallise losses by selling after a drop. And volatile securities tend to suffer in price as a result, making them theoretically higher reward.
But volatility is only one source of permanent loss, and not even the most important, that being fundamentals instead. Enron, for example, did not go belly-up because it was volatile, it was, near the end, volatile because of the risk that it would go belly-up.
Unfortunately, volatility's ease of measurement has put it at the centre of risk management, leading to all sorts of problems when, as in 2008, we get unprecedented volatility and correlation, leading to permanent loss that was never predicted by the risk management systems and experts in charge.
That line of thinking leads in an almost direct line to another canard Marks takes after: that the riskier the investment, the higher the reward.
While there is an upward slope in returns that correlates with risk, this is far from a mechanistic relationship. Just because investors generally get paid to carry risk does not mean you, the individual, will.
Risk, London Business School professor Elroy Dimson once wrote, "means more things can happen than will happen".
Better instead to think of the risk-reward relationship as a pool that gets deeper the further out you step. In the shallow, safer end, there are fewer things that can happen and lower rewards as a consequence. As the water gets deeper, the range of outcomes broadens and includes the possibility of drowning or, if you will, suffering permanent loss.
But even this pool is really a construct of investor perceptions. It does not have an actual measurable sloping floor, only depth guesses painted on the side that represent what the market thinks the risks may be.
One area that worries me is the way recent monetary policy has distorted our ability to detect risk. Because central banks, for the very noble cause of protecting the economy, have reacted to sharp market falls by easing policy, investors have been encouraged to see the stock market as a roller-coaster ride.
While that popular metaphor well describes the stock market's ups and downs, it also presupposes that there is a roller-coaster operator backed by engineers backstage somewhere.
It strikes me that one of the reasons we have been so long without a market correction is that "everyone knows" that corrections do not last and the secret is not to sell. That has been an excellent rule of thumb since 1998 or so, but it rather ignores fundamentals as a source of permanent loss of capital.
Two outcomes seem likely as a result of this.
First, investors will pay less attention to fundamentals than they formerly did, trusting in policy to rescue them if only they eat the magic risk pill in order to get the magic return. We are already seeing that, especially in credit markets. The outcome of that is poor allocation of capital, lower economic growth and, ultimately, lower investment returns, but over the long term.
The other outcome may take a while to arrive, but will do so suddenly and forcefully. At some point, policymakers will choose, or be forced, not to backstop a downdraft in markets.
That implies a lot of volatility, leading not to higher returns but to permanent loss.
