Why is risk often defined as volatility?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
userwithconcern
Posts: 194
Joined: Mon Dec 23, 2019 11:35 am

Why is risk often defined as volatility?

Post by userwithconcern »

Why is risk defined by most on here as volatility? Why aren't people allowed to have other interpretations of the term?

I have an incredibly low risk tolerance, but for me, the primary risk is inflation risk - I cannot get myself to hold a lot of cash or nominal assets like bonds. Paper money to me is not backed by anything and its value as history has shown several times in rich and poor countries can drop by several orders of magnitude when a few people in charge decide to print and spend more of it (several 0s get removed thereafter to not need to deal in billions and trillions all the time). I cannot rest easy having a large % of my net worth in cash/bonds - things ultimately not backed by real world productivity or assets.

And as far as TIPS, the supposed riskless asset that Bill Bernstein talks about goes, I need to trust both the US government to not default (backed by just a word and not secured by assets) and the government economists to calculate an inflation index that actually tracks cost of living, neither of which I do.

Plenty of governments around the world have defaulted on their sovereign debts after taking on too much, and plenty have had very high levels of inflation; and equities and real estate and other real assets in these places have consistently held their ground.

So I hold an index of the developed world equities (US Total Stock Market Index and Developed World (ex-US) Total Stock Market Index weighted by cap), which I deem to be the least risky intangible asset, as far as the risks I care the most about go. It may lose 60% or 70% of its value going by history, but cash can lose 99.999% of its value, making the balance situation much scarier with cash or other nominal assets like bonds. I could somehow live on 30% of my assets if I wanted to, but I definitely cannot live on 0.001% of my assets.

A question comes up here a lot, on what to do if you have say $10MM and people say you should stop "taking risk" with the money since "you have won the game". I don't get the reasoning here. If that $10MM became $3MM, the person will still be able to live an okay life in America. But what happens if the value of cash plummets to $1000? It's all gone.

Thoughts?
Dink2018
Posts: 113
Joined: Wed Sep 26, 2018 11:55 pm

Re: Why is risk often defined as volatility?

Post by Dink2018 »

Great topic. I agree with the premise that "risk" isn't simply volatility.

For me I've found that the RISK in my case presents itself like this...

RISK: that I don't earn enough / FIX - keep head down in business and make a killing

RISK: that I don't save enough of what I earn / FIX - keep personal expenses under $100k a year, I've been able to do this from $100k in earnings to $1M in earnings which is quite the mental battle

RISK: that I don't have enough insurance so I bought - health, business, life, umbrella, disability

RISK: Behavioral errors in my assets - FIX hired Vanguard Advisor (something I never thought I would do but after looking at 24 months of my own behavior I had to be honest with myself I wasn't following what I outlined

RISK: money printing (I agree with you here) that's why I hold 10% of net worth in gold. I can't see a lot of value in holding bonds with a 30-50+ year horizon so I might as well stack gold, stocks, business assets, cash, and some bonds.
rkhusky
Posts: 17765
Joined: Thu Aug 18, 2011 8:09 pm

Re: Why is risk often defined as volatility?

Post by rkhusky »

Volatility is easy to calculate and has nice mathematical characteristics. It’s also related to risk in some fashion.

In risk analysis, one needs to determine the probability that different risks will show up and the effect of the risks if they do show up.
User avatar
nisiprius
Advisory Board
Posts: 52216
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Why is risk often defined as volatility?

Post by nisiprius »

I think you are putting up a straw man when you say "Why is risk defined by most on here as volatility?"

The Bogleheads' Wiki article on Risk and return opens:
Risk and return is a complex topic. There are many types of risk, and many ways to evaluate and measure risk. In the theory and practice of investing, a widely used definition of risk is:
“Risk is the uncertainty that an investment will earn its expected rate of return.”
Nothing in that article says that risk is defined as volatility.

The article quotes John C. Bogle:
Consideration of bonds as an important asset class implicitly requires us to recognize, as I quoted in "Common Sense on Mutual Funds", that “risk is not short-term volatility, for the long term investor can afford to ignore that. Rather, because there is not a predestined rate of return, only an expected one that may not be realized, the risk is the possibility that, in the long-run, stock returns will be terrible." Put another way, the risk is that the investment portfolio might not provide its owner—individual or institution—with adequate cash to meet future requirements for essential outlays. In short, that the investor will lose a ton of money, just when it is needed the most.
I believe that volatility is one important kind of risk. I also believe that by and large, investments that have a lot of volatility usually have a lot of other kinds of risk, so it's not all that bad a proxy for risk in general.

There is a longstanding tradition in financial economics to use the word "risk" to refer to standard deviation. I don't think they should be blamed for having a technical vocabulary, any more than physicists should be blamed for defining "power" to mean energy per unit time, even though to some people it might mean military force.
And as far as TIPS, the supposed riskless asset that Bill Bernstein talks about goes, I need to trust both the US government to not default (backed by just a word and not secured by assets) and the government economists to calculate an inflation index that actually tracks cost of living, neither of which I do.
Then your investment decisions will be different from mine.

I've seen no credible evidence of major cheating by the Bureau of Labor Statistics, and their methodology is transparent, whereas the methodology of one vocal critic is opaque. During the time period when the MIT Billion Prices Project, which measures a price index by extracting price data from the web and is thus independent of the BLS, their index was in reasonably good accord with the CPI.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
bobcat2
Posts: 6076
Joined: Tue Feb 20, 2007 2:27 pm
Location: just barely Outside the Beltway

Re: Why is risk often defined as volatility?

Post by bobcat2 »

userwithconcern wrote: Sun Jun 28, 2020 7:28 pm Why is risk defined by most on here as volatility?
Investment risk, or speculative risk as it is sometimes called, isn't defined as volatility. Speculative risk is defined as uncertainty of an outcome, such as future stock returns.* Volatility, or standard deviation, is a good way to measure this risk because it takes into account both the probability and severity of the risk.

* To be a little more precise speculative risk is defined as uncertainty that is consequential (nontrivial). A coin tossing game at a penny a toss is uncertain but trivial. See my signature below.

People, including Bogleheads, often confuse the general definition of an investment risk with a particular investment risk. That's what you have done when you brought up inflation risk. Inflation is a risk because it is uncertain. But it is a particular investment risk, not the definition of investment risk in general.

Link - viewtopic.php?t=83960

Speculative risk
involves events in which either a gain or loss is possible. In general, people take speculative, or investment, risk by choice. Most other risks other than speculative risks are pure risks. Pure risks are events that can result in loss or no gain. Risk of physical injury, illness, accidents, and property damages are examples of pure risk. Generally, people don't take pure risk by choice. The financial aspects of pure risk can often be mitigated by insurance.

BobK
Last edited by bobcat2 on Mon Jun 29, 2020 5:07 pm, edited 2 times in total.
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
User avatar
patrick013
Posts: 3301
Joined: Mon Jul 13, 2015 7:49 pm

Re: Why is risk often defined as volatility?

Post by patrick013 »

A few thoughts on risk/reward.

Total risk: the chance you could lose all of your investment

Volatility: measures the risk of a return above or below the average

Beta (price): measures price movement compared to a market portfolio


Market volatility is usually caused by uncertainty, when prices adjust to
new economic conditions with reliable or tentative information that
becomes reliable. When actual history is close to market guesswork
less volatility is observed.


Inflation risk is hard to beat as a risk neutral approach doesn't produce
the needed total return desired in all cases. Hence a large stock AA
as returns are larger, inflation is correlated to stock returns, and
reinvestment leads to portfolio growth. So the thought is a large stock
AA comes from the desire to increase asset size, living budget excess,
and the lack of those extra large accounts from previous historical
investments.
age in bonds, buy-and-hold, 10 year business cycle
User avatar
ResearchMed
Posts: 16795
Joined: Fri Dec 26, 2008 10:25 pm

Re: Why is risk often defined as volatility?

Post by ResearchMed »

bobcat2 wrote: Sun Jun 28, 2020 8:32 pm
userwithconcern wrote: Sun Jun 28, 2020 7:28 pm Why is risk defined by most on here as volatility?
Financial risk isn't defined as volatility. In finance, risk is defined as uncertainty of an outcome such as future stock returns.* Volatility, or standard deviation, is a good way to measure financial risk because it takes into account both the probability and severity of financial risk.

* To be a little more precise in finance risk is defined as uncertainty that is consequential (nontrivial). A coin tossing game at a penny a toss is financially uncertain but trivial. See my signature below.

People, including Bogleheads, often confuse the general definition of financial risk with a particular financial risk. That's what you have done when you brought up inflation risk. Inflation is a risk because it is uncertain. But it is a particular financial risk, not the definition of financial risk in general.

Link - viewtopic.php?t=83960

Financial risk
, or speculative risk, as it sometimes is called, involves events in which either a gain or loss is possible. In general, people take financial risk by choice. Most risks outside of finance are pure risks. Pure risks are events that can result in loss or no gain. Risk of physical injury, illness, accidents, and property damages are examples of pure risk. Generally, people don't take pure risk by choice.

BobK
About the time I discovered Bogleheads, we had some money managed by suits at Merrill Lynch-who-then-moved-to-Morgan Stanley, for about 3 years.

I think they were a bit annoyed with us because we insisted that certain holdings remain separate, without any fees (they reluctantly agreed), and most of our money was in 403b accounts anyway, which they couldn't "manage", although they did include those holdings in our "planning".
They were hoping to get their hands on our 403b money when DH retired, but he didn't (not yet!) anyway, despite his age.
:wink:

And I will never forget when they repeatedly insisted that "risk" was exactly equal to "volatility" in finance, despite [naive at that time] arguments from me. But those were very strong arguments, and even now, I wouldn't consider them wrong (unless someone insisted on the terms as definitionally equivalent, which they apparently did).
They would not budge from that position that "risk = volatility", and they further insisted that that was "THE" proper definition in "finance".
Thinking back, they were only slightly sleazy, albeit not for that reason.

But it's very interesting to read of finance professionals NOT defining risk as volatility, given that it seemed somewhat religious to them.

RM
This signature is a placebo. You are in the control group.
acegolfer
Posts: 3029
Joined: Tue Aug 25, 2009 9:40 am

Re: Why is risk often defined as volatility?

Post by acegolfer »

OP, you got it wrong. Volatility is not risk. Instead, it's "a measurement" of risk. There are other measurements but stdev is arguably the most popular method. The problem with this is many ppl like you now think volatility is the only risk.
Seasonal
Posts: 3045
Joined: Sun May 21, 2017 1:49 pm

Re: Why is risk often defined as volatility?

Post by Seasonal »

Modern Portfolio Theory used volatility as risk because it was relatively easy to calculate back when Markowitz developed it in the 1950s. It's still easy to calculate and teach, even if finance theory has moved on since then.

To me, risk is the chance that you will not have enough money when you need (or want) it. This concept is not easy to quantify. Finance theory likes math and therefore uses measures that can be quantified and calculated.
User avatar
nisiprius
Advisory Board
Posts: 52216
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Why is risk often defined as volatility?

Post by nisiprius »

By the way, don't kid yourself about the risks of stocks. If you were caught up in the mania in 1929--and a lot of people were, I don't have numbers but it didn't take unbelievable bad luck to buy near the top--this is how stocks and bonds performed; dividends reinvested, inflation-adjusted.

Stocks are riskier than bonds in many ways, even if not all.

In The Great Depression, A Diary, Benjamin Roth often laments not having invested money in government bonds.

Image
Last edited by nisiprius on Mon Jun 29, 2020 7:57 am, edited 2 times in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
nisiprius
Advisory Board
Posts: 52216
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Why is risk often defined as volatility?

Post by nisiprius »

...cash can lose 99.999%...
In a true hyperinflation situation, certainly, but all kinds of things happen. People will offer you snake oil to protect you but IMHO there isn't really any cheap or reliable insurance.

"Cash" is a loaded term because it means more than one thing, and when people are trying to advocate for risky investments they are likely to define "cash" literally--as physical paper currency. But who keeps much in literal cash... or in a non-interest-bearing bank account? At a rough estimate, I have less than 0.1% of my "cash" in the form of currency. The rest is where it should be, in interest-earning bank accounts chosen to have reasonably competitive rates.

The nearest thing to the idealized "riskless asset" is often said to be Treasury bills; and money market mutual funds and bank accounts track the Treasury bill interest rate reasonably closely, so we can use Treasury bills as a proxy for most forms of interest-earning cash. For example, as I write this, my largest savings account--at a local brick-and-mortar bank which tends to have "sorta ok" rates--is paying 0.65%, while Treasury bills are earning 0.12%.

As a matter of fact Treasury bills are one of the traditional "inflation hedges," and over the time period 1926-2019 Treasury bills eked out an average (CAGR) real return of 0.44%. That is, they did not actually lose anything to inflation.

The results are not so good if you look at shorter periods of time; the average (CAGR) over overlapping twenty-year periods has ranged from about +3% to -3%, the very worst to date being -3.04% for 1933-1952 which is pretty horrible, meaning $1.00 at the start was worth only $0.54 at the end. But it's still a loss of -46%, not anything like the -99.999% you are talking about.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
firebirdparts
Posts: 4414
Joined: Thu Jun 13, 2019 4:21 pm
Location: Southern Appalachia

Re: Why is risk often defined as volatility?

Post by firebirdparts »

userwithconcern wrote: Sun Jun 28, 2020 7:28 pm Why aren't people allowed to have other interpretations of the term?
Don't play the victim.

You need to re-imagine how you see inflation. Inflation is simply a moving target environment. The risk presented by inflation is that your investments will fall behind the moving target, and somewhere down the road, you will not have as much money as you wanted to. As a result, you get thrown right back into the same reality as the rest of us. It turns out that is the only risk of any of us are actually trying to apprehend and control.

There is a lot of delusion about volatility, but that's not really the problem in our present world of low returns. I'll just not worry about that.
This time is the same
tvubpwcisla
Posts: 1167
Joined: Sat Nov 09, 2019 9:09 am

Re: Why is risk often defined as volatility?

Post by tvubpwcisla »

Robot Monster
Posts: 4215
Joined: Sun May 05, 2019 11:23 am

Re: Why is risk often defined as volatility?

Post by Robot Monster »

nisiprius wrote: Mon Jun 29, 2020 7:05 am By the way, don't kid yourself about the risks of stocks. If you were caught up in the mania in 1929--and a lot of people were, I don't have numbers but it didn't take unbelievable bad luck to buy near the top--this is how stocks and bonds performed; dividends reinvested, inflation-adjusted.

Stocks are riskier than bonds in many ways, even if not all.

In The Great Depression, A Diary, Benjamin Roth often laments not having invested money in government bonds.

Image
The 3.60% yield a 10-yr Treasury got in 1929 looks tantalising compared to the .64% that it gets today. Many people would say, surely bonds today cannot outperform stocks with rates being so in the gutter. (Mind you, I'm not of this opinion because below the gutter might be an abyss of negative interest rates...not to mention the possibility of a deflationary spiral.)

Sources:
https://www.multpl.com/10-year-treasury ... le/by-year
https://www.bloomberg.com/markets/rates ... t-bonds/us
adam1712
Posts: 566
Joined: Fri Jun 01, 2007 5:21 pm

Re: Why is risk often defined as volatility?

Post by adam1712 »

I believe risk is always the same. It is the range of possible returns for an investment and the probability that each of those returns will happen. What changes is how people choose to model that risk and then the risk management strategy they take.

It’s been found that the volatility of stock returns as measured by standard deviation for an individual stock or fund has been surprisingly good (maybe not that surprising if you consider probability theory and the central limit theorem) at predicting the range and probability of future returns. And it's also not perfect given fat tails of investments and such. For fund managers or investment bankers, however, this model has worked well and they don’t need much of a risk management strategy as they are mainly worried about total returns and a single investment going belly up isn’t the end of the world to their personal lives.

As you rightly point out, individual investors should often place more emphasis on especially low returns by adjusting their risk management strategy by adding a utility factor to the various expected returns. I still believe it’s wise, however, to be realistic about modeling the expected returns and then adjust from there. I’d never make my risk decisions based only on the worst outcomes but I’m not you. Maybe you truly only care about the very worst outcome and don’t care about the overall risk model, but I think it’s really important that your eyes are open to that is what you are doing.
dbr
Posts: 46181
Joined: Sun Mar 04, 2007 8:50 am

Re: Why is risk often defined as volatility?

Post by dbr »

Good grief. This is a commonplace discussion about how someone chooses to use a word in one context or another. It is all obvious and there is nothing to see here.

Now, to be constructive and answer the question, if you do want to talk about the investment property of return it will become evident that returns over time from period to period (day, month, year) are quite variable in a sort of random way. That being the case a description of return is best formulated as a statistical distribution that can be described by a mean value and by some statistics that tell us how wide the distribution is. The simplest of the latter is the standard deviation of annual returns, technically volatility. For some perverse reason academics who study this chose the word "risk" to label this. That volatility of annual returns would be viewed by people as a risk is reasonable. Diverting commonplace terms to use as a technical term specific to a discipline usually does not end well. More than that, many other "risks" that people nominate can be inferred, sometimes actually calculated, from volatility, such as max drawdown and the role volatility plays in estimating safe withdrawal rate.

That is all.
dbr
Posts: 46181
Joined: Sun Mar 04, 2007 8:50 am

Re: Why is risk often defined as volatility?

Post by dbr »

userwithconcern wrote: Sun Jun 28, 2020 7:28 pm Why is risk defined by most on here as volatility? Why aren't people allowed to have other interpretations of the term?
Second reply. It isn't and you are.

There is massive amounts of discussion of all kinds of risk in investing.

I could mention two that are endlessly discussed:

1. What is the safe withdrawal rate?

2. What does it take to sleep well at night?

A warning is that thinking volatility is not very important to thinking about investments would be a big mistake.
oldfort
Posts: 2781
Joined: Mon Mar 02, 2020 7:45 pm

Re: Why is risk often defined as volatility?

Post by oldfort »

Volatility isn't a perfect measure of risk, as it includes changes on the upside and downside. Other statistics, such as value at risk, provide a better measure of the risk of losing money. The riskiness of an asset depends on the time frame you're looking at. Over short time periods, stocks are riskier than cash or bonds. Over the long run, inflation risk starts to overtake stock market volatility, at least for cash and nominal bonds. Most people treat the risk of USG default as zero or as close enough to zero to be ignored for all practical purposes.
oldfort
Posts: 2781
Joined: Mon Mar 02, 2020 7:45 pm

Re: Why is risk often defined as volatility?

Post by oldfort »

userwithconcern wrote: Sun Jun 28, 2020 7:28 pm Plenty of governments around the world have defaulted on their sovereign debts after taking on too much, and plenty have had very high levels of inflation; and equities and real estate and other real assets in these places have consistently held their ground.

So I hold an index of the developed world equities (US Total Stock Market Index and Developed World (ex-US) Total Stock Market Index weighted by cap), which I deem to be the least risky intangible asset, as far as the risks I care the most about go. It may lose 60% or 70% of its value going by history, but cash can lose 99.999% of its value, making the balance situation much scarier with cash or other nominal assets like bonds. I could somehow live on 30% of my assets if I wanted to, but I definitely cannot live on 0.001% of my assets.


Thoughts?
Historically, there have been examples of stock markets going to zero. Think of China, Russia and all the communist countries which nationalized their corporations. IIRC, the German and Japanese stock markets went nearly to zero at the end of WWII.
User avatar
WoodSpinner
Posts: 3505
Joined: Mon Feb 27, 2017 12:15 pm

Re: Why is risk often defined as volatility?

Post by WoodSpinner »

userwithconcern wrote: Sun Jun 28, 2020 7:28 pm Why is risk defined by most on here as volatility? Why aren't people allowed to have other interpretations of the term?

I have an incredibly low risk tolerance, but for me, the primary risk is inflation risk - I cannot get myself to hold a lot of cash or nominal assets like bonds. Paper money to me is not backed by anything and its value as history has shown several times in rich and poor countries can drop by several orders of magnitude when a few people in charge decide to print and spend more of it (several 0s get removed thereafter to not need to deal in billions and trillions all the time). I cannot rest easy having a large % of my net worth in cash/bonds - things ultimately not backed by real world productivity or assets.

Thoughts?
OP,

My immediate thought is that we have very different opinions on the likelihood of different risks actually manifesting.

For instance, I have almost no concern around hyper-inflation of the USD in the near or far term — at least as of today. I am much more concerned around deflation at this point (as is the Fed) than inflation.

I view our stock investments much as more risky (by at least an order of magnitude) than my fixed income investments (short/intermediate term treasuries). There is almost no chance that an Investment in equities is a less risky investment than in a US Government obligation (or backed by the government, e.g. FDIC).

At this point We are retired and the financial risk We are most focused on is not having enough to spend on experiences now while maintaining a comfortable portfolio to fund expenses in the future. Said another way, we are in the Go-Go years of Retirement and don’t want to miss out, but we need to make sure our slow-go and no-go needs are covered as well.

To be clear, I have no crystal ball, just an informed opinion based on reading and listening to others much smarter than myself.

WoodSpinner
Last edited by WoodSpinner on Mon Jun 29, 2020 3:11 pm, edited 1 time in total.
WoodSpinner
dbr
Posts: 46181
Joined: Sun Mar 04, 2007 8:50 am

Re: Why is risk often defined as volatility?

Post by dbr »

Note that inflation risk becomes part of volatility if the returns are real returns.
User avatar
KEotSK66
Posts: 364
Joined: Wed Mar 11, 2020 7:03 pm

Re: Why is risk often defined as volatility?

Post by KEotSK66 »

userwithconcern wrote: Sun Jun 28, 2020 7:28 pm Why is risk defined by most on here as volatility? Why aren't people allowed to have other interpretations of the term?

I have an incredibly low risk tolerance, but for me, the primary risk is inflation risk - I cannot get myself to hold a lot of cash or nominal assets like bonds. Paper money to me is not backed by anything and its value as history has shown several times in rich and poor countries can drop by several orders of magnitude when a few people in charge decide to print and spend more of it (several 0s get removed thereafter to not need to deal in billions and trillions all the time). I cannot rest easy having a large % of my net worth in cash/bonds - things ultimately not backed by real world productivity or assets.

And as far as TIPS, the supposed riskless asset that Bill Bernstein talks about goes, I need to trust both the US government to not default (backed by just a word and not secured by assets) and the government economists to calculate an inflation index that actually tracks cost of living, neither of which I do.

Plenty of governments around the world have defaulted on their sovereign debts after taking on too much, and plenty have had very high levels of inflation; and equities and real estate and other real assets in these places have consistently held their ground.

So I hold an index of the developed world equities (US Total Stock Market Index and Developed World (ex-US) Total Stock Market Index weighted by cap), which I deem to be the least risky intangible asset, as far as the risks I care the most about go. It may lose 60% or 70% of its value going by history, but cash can lose 99.999% of its value, making the balance situation much scarier with cash or other nominal assets like bonds. I could somehow live on 30% of my assets if I wanted to, but I definitely cannot live on 0.001% of my assets.

A question comes up here a lot, on what to do if you have say $10MM and people say you should stop "taking risk" with the money since "you have won the game". I don't get the reasoning here. If that $10MM became $3MM, the person will still be able to live an okay life in America. But what happens if the value of cash plummets to $1000? It's all gone.

Thoughts?
you might be looking at asset classes in isolation

it is helpful to understand the risks involved with individual asset classes but you might look at the net result of holding some of each of those asset classes you mentioned, the purpose of asset allocation after all is to achieve a level of return at lower risk/SD/volatility
"i just got fluctuated out of $1,500", jerry
dbr
Posts: 46181
Joined: Sun Mar 04, 2007 8:50 am

Re: Why is risk often defined as volatility?

Post by dbr »

userwithconcern wrote: Sun Jun 28, 2020 7:28 pm

A question comes up here a lot, on what to do if you have say $10MM and people say you should stop "taking risk" with the money since "you have won the game". I don't get the reasoning here. If that $10MM became $3MM, the person will still be able to live an okay life in America. But what happens if the value of cash plummets to $1000? It's all gone.
When we use the range of variation in annual returns as the meaning of risk, we have in mind an observed distribution that is fat in the middle and has long tails to the high and low sides. That means small changes in return are likely and large changes in return are unlikely. It is highly possible to get a change in return by, say 3%, from 4% one year to 7% the next year, or to 1% if the change is a loss. For $10M to change to $3M you would need return that year of -70% compared to a more typical range of -4% to +11%, say. That is very unlikely. The chances of getting a return of -99.99% is so unlikely in the US stock market as to be considered impossible. At least it would require some kind of social, political, and economic upheaval as to make the whole concept of investing in and owning stocks meaningless. Note such losses have happened in some economies due mainly to war or revolution.

The next step in the whole thing is to track how things happen when there is a succession of returns sequentially over time. In that case the value of the portfolio will experience compound growth. When that is done by compounding a set of probability distributions the result will be a probabilityle distribution for the compound growth that will have a type of average, called the expected return, and volatilty called the compounded expected volatility. In general if there is a large loss one year or for a couple of years then in following years there will be gains. There are no longer stretches of time when the US stock market averaged a compound loss. The compounded expected volatility is less than the annual volatility. Even so the volatility of the portfolio balance increases with time. For some simple distributions the compounded volatility shrinks with the square root of time and the end portfolio volatility increases with the square root of time.

Don't forget that in this model for how returns are understood we are talking about the means and variations in annual returns and not the means and variations of portfolio value. The returns are the changes in portfolio values. Portfolio value over time is the result of compound growth where the growth factor is (1 + return%/100).
User avatar
patrick013
Posts: 3301
Joined: Mon Jul 13, 2015 7:49 pm

Re: Why is risk often defined as volatility?

Post by patrick013 »

userwithconcern wrote: Sun Jun 28, 2020 7:28 pm
Why is risk defined by most on here as volatility? Why aren't people allowed to have other interpretations of the term?

I think there's a difference between observed statistical risk
in SD, beta, and TR/SD, and factor risk.

In APT the risk represented by a factor-specific beta coefficient
which changes thru time is worth watching for changes affecting
stock valuation. This could be anything affecting the market
from rainfall to mortgage defaults to over-production. An
attempt to identify some risk as a factor risk in an objective
analysis for the entire market or a specific sector will eventually
identify this risk either before or sometimes after it occurs.

Gas at $1.99 is certainly good to hold down inflation, houses
on the market for sale without an offer for ten years certainly
doesn't lead to optimism there. COVID is affecting the entire
market so that risk needs to be considered anew. So what is
the risk that is causing the risk in a nutshell apart from conceptual
diversification theory and it's resulting portfolio AA's.
age in bonds, buy-and-hold, 10 year business cycle
02nz
Posts: 10510
Joined: Wed Feb 21, 2018 2:17 pm

Re: Why is risk often defined as volatility?

Post by 02nz »

acegolfer wrote: Mon Jun 29, 2020 6:05 am OP, you got it wrong. Volatility is not risk. Instead, it's "a measurement" of risk. There are other measurements but stdev is arguably the most popular method. The problem with this is many ppl like you now think volatility is the only risk.
To be more precise: Volatility is "a measurement" of one kind of risk. There are other measurements, but there are also other risks, e.g., inflation risk.

Alternatively, you could say that volatility is "a manifestation" of risk (that's a slightly different meaning of risk - more general/abstract).
Northern Flicker
Posts: 15365
Joined: Fri Apr 10, 2015 12:29 am

Re: Why is risk often defined as volatility?

Post by Northern Flicker »

Volatility is the sample standard deviation of short-term nominal returns. It is one risk measure. It is a useful one. It is more relevant to retirees withdrawing from their portfolio than to young savers with a long investment horizon.

Another risk measure I care about is the variance of longer term real returns. This wraps both investment risk and inflation risk into one measure. It captures the risk of a young saver not having a sufficient return to meet their retirement objectives. It also captures risks that only tend to show up over a longer horizon.
Call_Me_Op
Posts: 9881
Joined: Mon Sep 07, 2009 2:57 pm
Location: Milky Way

Re: Why is risk often defined as volatility?

Post by Call_Me_Op »

userwithconcern wrote: Sun Jun 28, 2020 7:28 pm Why is risk defined by most on here as volatility? Why aren't people allowed to have other interpretations of the term?
It's not just "on here." The academics use volatility (standard deviation) because it is easy to measure. You are free to use whatever definition you like.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein
DetroitRick
Posts: 1488
Joined: Wed Mar 23, 2016 9:28 am
Location: SE Michigan

Re: Why is risk often defined as volatility?

Post by DetroitRick »

I don't define that way. But I do find it relevant to understand how others use that term in discussions and articles that focus on risk.

I'm not an academic and, while the concept of volatility is vaguely important to me, other factors are of substantially greater concern in my own portfolio design and management. Random examples off the top - prolonged inflation, deflation, risk of massive losses, real estate trends, technology trends, and a whole host of other things. To each their own - you should use whatever tools you find useful. Even though I'm retired, I still only find the volatility concept to have marginal use. Yes, I can compute standard deviation. But I often choose not to.
Post Reply