Let’s clear up misunderstandings about risk and volatility

Field of play

Spiders and other creepy crawlies

J.P. Morgan is reputed to have said, when asked about the future course of stock market prices: “They will fluctuate.” (Graham, The Intelligent Investor, fourth revised edition, 1973) p. 23. Simple and obvious as this observation seems, it contains a truth that investors need to reflect on.

Volatility is the up and down swings of the stock market, or of individual stocks, that takes place constantly. Volatility can refer to movements over the course of a day or even part of a day. It can also refer to swings that take place over months or years. Many investors have an instinctive dislike for volatility. It is almost like a fear of spiders or other creepy crawlies.

Pundits and the financial press

The financial press and stock market pundits take advantage of this aversion to report regularly on volatility statistics. The stock market ‘plunges’ 1.5% in a day and the media has a field day reporting on the number of drops exceeding one percent that have taken place in the last year compared with the average in the last decade. This sells newspapers and draws eyeballs and ears.

How we react

Various questions come up about volatility. Should we ignore it? Can and should we try to avoid it? Or even, can we take advantage of it? The answers to these questions should not depend at all on whether we have a negative visceral reaction to volatility. It should depend on what is best for our investment results over the long term.

It is better to read about volatility, learn all you can and gradually desensitize yourself to market swings. Fear of spiders can be conquered by learning how many are poisonous in your geographic region and, of the ones that are poisonous (very few), what is the consequence of being bitten: risk of death or something like a mosquito bite. This might be coupled with purposely touching spider webs and even touching or picking up a spider. This approach is somewhat akin to a course of cognitive behavioral therapy.

Ignoring stock market volatility is not a bad course of action. Better though is to take advantage of it. Worst is to seek to avoid it by focusing on buying low volatility stocks.

Sharpe ratio

For the rest of this post I want to focus on the Sharpe Ratio. What it purports to measure is risk adjusted return (RAR). It is mentioned all the time by asset managers, investment advisors and money managers. It is also a fundamentally flawed construct. If you can understand the Sharpe Ratio and also understand why it is completely mistaken, you will have made a big leap forward in your investment education.

The Sharpe Ratio is calculated by dividing the actual return achieved minus the risk-free return by the standard deviation of the return. The idea behind this measure is the assumption that one can only increase return by increasing risk. It is supposed to answer the question whether the portfolio manager is buying performance by taking on too much risk. The question is a good one. The solution is not.

Robert Hagstrom writes: “Sharpe was awarded the 1990 Nobel Prize in economics for developing ‘a market equilibrium theory of asset prices under conditions of risk.’ His theory was originally outlined in a 1964 paper entitled ‘Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.’ Sharpe explained, ‘In equilibrium, there is a simple linear relationship between the expected return and standard deviation of return (defined as risk).’ Accord to Sharpe, the only way to achieve a greater return is to incur additional risk.” (Hagstrom, Investing – The Last Liberal Art, 2000)p.48.

Problems with the Sharpe ratio

There are several problems with the Sharpe Ratio.

First there is its mistaken assumption that the stock market is efficient. In fact it isn’t. it’s messy and inefficient. See my thoughts here.

Second, is the mistaken assumption that volatility is a measure of risk or a reasonable proxy for measuring risk. Warren Buffett is reported to have written in the Outstanding Investor Digest August 8, 1997: “Finance departments teach that volatility equals risk. Now they want to measure risk. And they don’t know any other way, they don’t know how to do it, basically. So they say that volatility measures risk. I’ve often used the example of the Washington Post stock when we first bought it: In1973, it had gone down almost 50%, from a valuation of the whole company of close to say $180 or $175 million, down to maybe $80 million or $90 million. And because it happened very fast, the beta of the stock had actually increased. A professor would have told you that the stock of the company was more risky if you bought it for $80 million than if you bought it for $170 million, which is something that I’ve thought about ever since they told me that 25 years ago. And I still haven’t figured it out.”

Third, optimizing Risk Adjusted Returns using the Sharpe Ratio does not optimize returns on a portfolio. The winning portfolio using Sharpe Ratios for comparative purposes is the one with the highest score based on return and volatility. Some investors may prefer this if they don’t understand volatility. I have written about the fallacy of the risk/reward idea here.

My discount brokerage provider has an investor community designed to allow the brokerage clients to exchange ideas using pseudonyms. The service allows one to look at the risk adjusted returns of other investors and look at their portfolios without any breach of confidentiality. I have looked at a number of portfolios with various RARs. Looking at the portfolios shows the flaws of the RARs concept. One portfolio will illustrate this. It was a portfolio that over two or three years showed a very high RAR. The portfolio contained five stocks and each and every one was a Canadian bank stock. This portfolio is certainly risky. First, because the portfolio contains only five stocks it is vulnerable to a catastrophic idiosyncratic loss in any one of its holdings. A bank can get blown away by a rogue trader. Secondly, all the holdings are in the same industry. At the time The Economist magazine rated Canada’s housing market as amongst the most overpriced in the world. The Canadian banking sector was vulnerable to their customers’ vulnerability to a rise in mortgage rates. It is not implausible to think that as a result of this or some other factor affecting Canadian banks, the Canadian banking sector could simultaneously underperform the rest of the stock market even in a healthy economy. No doubt a similarly structured portfolio would have taken a major hit in the financial crisis in 2008. Canadian bank stocks fell more than 50% from their previous highs. Their fall was somewhat greater than that of the S&P/TSX Composite. But, this portfolio had a high RAR.

My point, very simply, is that a poorly diversified portfolio can show a good Sharpe Ratio for even a fairly long period of time. My original criticism of the Sharpe Ratio was that it was in error in using volatility as a proxy for risk. My further criticism is that it fails to pick up the increased risk that comes from a poorly diversified portfolio. It may also be dangerous. It is possible that benchmarking based on Sharpe Ratios ignores tail risk. That is, a portfolio may show a good Sharpe Ratio and thus be considered as having a good risk adjusted return. However, the low volatility may overlook a potential portfolio killer of a risk that occurs only once in thirty years.

A risky investment may be volatile, but not every volatile investment is risky.

Stocks, by their nature, are much more volatile than bonds. But, the added volatility is not a fair measure of their risk. In fact, there are times, in an inflationary environment with increasing bond rates for example, when bonds are at a greater risk of capital loss than stocks. Yet, in those environments, the volatility of bonds may be very low.

No doubt high volatility stocks also include: (1) companies with inferior business prospects; (2) more levered balance sheets; (3) promotions; (4) concept stocks; (5) speculations; (6) stocks whose very volatility attract investors who believe high volatility stocks will perform better; and so on.

By the same token, the stock prices of some large conservative companies can be quite volatile. They may be in a sector that is inherently volatile, such as manufacturing or chemicals. A company whose share price is generally of low volatility may do a large acquisition or divestiture that causes large price swings. And of course, the stock price of a small company may stay within a fairly narrow band for an extended time. Some companies with a relatively low float of shares on the market (a controlling shareholder or group own most of the shares) may be volatile or stable. Banks and utilities are companies that have tended to exhibit lower volatility. Investors must realize that banks have a highly leveraged business model. They occasionally make major blunders and suffer huge losses. And sometimes they get caught up in financial crises and their stability evaporates.

No public company is immune to volatility.

Risks from lack of volatility

We’ve all heard of the expression, ‘the calm before the storm’. The irony from the financial crisis in 2008 is that it took misbehavior by ostensibly low volatility (supposedly low risk) investments to show that the equation of volatility and risk was wrong.

A book published in 2012, just a few short years after the financial crisis of 2008 was titled, The Taylor Rule, and the Transformation of Monetary Policy. It was edited by Evan F. Koenig, Robert Leeson and George A. Kahn. (Koenig, 2012)

It contains a chapter titled “The Great Moderation” by Ben Bernanke, Chairman of the Federal Reserve through the financial crisis to 2014. It was based on a speech he gave in 2004, before the financial crisis. He writes “One of the most striking features of the economic landscape over the last twenty years or so has been a substantial decline in economic volatility. In a recent article Oliver Blanchard and John Simon (2001) documented that the variability of quarterly growth in real output (as measured by its standard deviation) has declined by half since the mid-1980s while the variability of quarterly inflation has declined by about two-thirds.

Several writers on the topic had dubbed this remarkable decline in the variability of both output and inflation ‘The Great Moderation’.” (Koenig, 2012)p.145.

The Great Moderation was succeeded by what another author in the book calls “the Great Deviation”, the financial crisis of 2008. The Great Moderation was simply the calm before the storm. In investing, as in economics, one should be wary of calm waters or of seemingly calm waters.

One might even go so far as to say that lack of volatility in markets should cause the wary investor heighted concern. The word ‘volatility’ has actually received a bad rap by being associated with risk.

Conclusion

Let me conclude by going back to J.P. Morgan’s comment about stock market prices: “They will fluctuate.” Get used to it.

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For further reading take a look at The joy of higher return with no more risk

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You can reach me by email at rodney@investingmotherlode.com

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