Never confuse risk and volatility in investing

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.