Volatility and Risk
We simply do not know
In this post I take issue with Cliff Asness’ thoughts on Risk Adjusted Returns (RAR) in a recent article. This issue is important as it cuts to the heart of asset allocation and portfolio construction.
In two articles written 28 years apart, here and here, Asness accepts the proven superior returns of common stocks over the long haul but says investors who rely on this can fail to carry out an analysis of return versus risk. He says an asset allocation including bonds, cash and even leverage through debt can provide a superior Risk Adjusted Return.
Returns and the risk taken
Asness makes the valid point that returns achieved cannot be separated from the risks taken to achieve those returns. Taking a higher risk does not guarantee higher returns. But, in achieving a higher return by taking a higher risk, the risk taken should be taken into account.
Where I disagree with Asness is on the question of whether risk can be measured. Asness whole approach depends on the use of Risk Adjusted Returns (RAR). I capitalize this term because it is a term of art in finance.
Sharpe Ratio
It is otherwise known at the Sharpe Ratio. The Sharpe Ratio (RAR) is calculated by dividing the actual return achieved (or the expected return in a forward-looking analysis) minus the risk-free return by the standard deviation of the portfolio. William F Sharpe was awarded the 1990 Nobel Prize in economics.
The problem with the Sharpe ratio is that its validity depends completely on the assumption that volatility is a good measure of risk, or a proxy for risk or a good indicator of risk. I have thought about this one a lot. For the life of me I can’t see how volatility measures risk. And, if volatility is not a good measure of risk, the whole house of cards of RAR comes tumbling down.
Risk in investing
We have to start by making clear what is meant by risk in investing. When I’m investing, the risks I face are business risks of the companies I invest in, risks in the economy, inflation risks, interest rate risks, liquidity risks, currency risks, and so on.
Consider Warren Buffett’s aphorism in the 2008 Berkshire Hathaway annual report: “Price is what you pay. Value is what you get.” Once you own shares in a company, the investment risk you face is a risk that undermines the value of what you own – value risk. Price volatility does not affect value risk.
So, the question is whether volatility in an asset price, a stock price or in a portfolio price is a good measure of those risks. Hold that thought.
About some things we just do not know
John Maynard Keynes was the well-known British economist who lived is the first half of the 20th century. He began life as a mathematician. He studied at Eaton College (1897–1902) and at King’s College, Cambridge, where he received a B.A. in mathematics in 1905. Having completed a revised dissertation on probability, he was elected a fellow of King’s College in 1909.
Keynes distinguished between three kinds of knowledge: Certain, probable and uncertain.
Bernstein references Keynes views written in 1937: “By ‘uncertain’ knowledge… I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty… the sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention…About these matters, there is no scientific basis on which to form any calculable probability whatever. We simply do not know!” (Bernstein, Against The Gods – The Remarkable Story of Risk. 1996) p229
Looked at this way, when it comes to business risks of the companies I invest in, risks in the economy, inflation risks, interest rate risks, liquidity risks, currency risks “there is no scientific basis on which to form any calculable probability whatever. We simply do not know!” That is, you cannot measure these risks.
What I do know is that a high-tech start-up with nothing more than a business plan is a far riskier investment than Microsoft. What I also know is that there is no way to put a number on the difference in riskiness between the two. Nor do I need to put a number on it.
Better vaguely right than precisely wrong
Where does this leave us? In his 1986 Chairman’s letter to the shareholders of Berkshire Hathaway, Buffett observes that we agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”
Applying that, I would say that I would rather be vaguely right about the riskiness of a stock or asset class than precisely wrong using volatility as a measure of risk.
Volatility is not a true risk
Let’s see what Ben Graham and Warren Buffett have to say about this. Consider the following from Benjamin Graham: “…the idea of risk is often extended to apply to a possible decline in the price of a security, even though the decline may be of a cyclical and temporary nature and even though the holder is unlikely to be forced to sell at such times. These chances are present in all securities, other than United States savings bonds, and to a greater extent in the general run of common stocks than in senior issues as a class. But we believe that what is here involved is not a true risk in the useful sense of the term.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p60 (Emphasis added)
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.”
In an August 2002 report, Michael Mauboussin and Alexander Schay take issue with these views expressed by Buffett, particularly with his example of Washington Post stock. They write:
“We agree with Peter Bernstein, who notes that ‘volatility, or variance, has an intuitive appeal as a proxy for risk.’ He adds, ‘If you were asked to rank the riskiness of shares of the Brazil Fund, shares of General Electric, a U.S. Treasury bond due in thirty years, and a U.S. treasury bill due in ninety days, the ranking would be obvious. So would the relative volatility of the securities.’
Relative risk is no measure of risk
And therein lies the problem. It’s one thing to point to relative volatility and relative riskiness. It is quite a different matter to conclude that volatility can be used as a measure of risk. You risk being precisely wrong rather than vaguely right.
A four bank portfolio
Let me give you an example. Suppose you had constructed a portfolio of four major banks in late 2002 when the bear market following the Dot Com bust ended. You track the RAR of the portfolio for five years through 2007. The portfolio would have achieved a superb RAR. And yet the portfolio was supremely high-risk, lacking diversification. The portfolio was brutalized in 2007-08. This is not a made-up example. My discount broker had an investor community feature at that time that showed, on an anonymous basis, other investor portfolios and tracked their RARs. This was one of the portfolios I saw.
Bonds
As between stocks and bonds, two asset classes, most investors accept that stocks are riskier than bonds. That may be true. Common shareholders rank behind bond holders in a breakup. Most analyses take the ten-year U.S. Treasury Bond as risk free. Of course it isn’t. it is subject to both inflation and interest rate risks. Even inflation protected bonds can suffer capital losses when the Fed is rapidly raising rates. Quantitative tightening by the Fed can even cause capital losses in long bonds. In 2022 we saw that bonds were at great risk of capital loss. And yet it was an environment when the volatility of bonds was low.
I personally dislike bonds. The quality of bonds goes down as you reach for yield. That is, higher return equals lower quality. With stocks, higher returns come from higher quality.
The equity risk premium (the added return that stock investors get over bonds) might ironically be in part the result of investor distaste for volatility. That is, equities may offer higher returns in part because investors don’t like volatility.
Perversity of risk
Howard Marks is Chairman and Cofounder of Oaktree Capital Management, a Los Angeles-based investment firm. He has a finance degree from Wharton and an MBA from the University of Chicago. He is the author of The most important thing illuminated – Uncommon Sense for Thoughtful Investors published in 2013. (Marks, 2013) He has a wonderful expression, perversity of risk, to describe risks going down in down markets and up in up markets. He writes: “Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the “perversity of risk.” (Marks, 2013) p68 (emphasis added)
Stock volatility
I’ll accept that there are lots of public companies with especially volatile stock prices. These would include: (1) companies with inferior business prospects; (2) more levered balance sheets; (3) promotions; (4) concept stocks; (5) speculations; and so on. They probably make the stock market averages even more volatile.
Even the stock prices of some large conservative companies can be quite volatile. They may be in a sector that is inherently volatile, such as technology, 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.
On the other hand, some public companies have very stable prices. Many of these are companies in their declining years playing out the string, cash cows, with little future. Their low price-volatility may be a harbinger of their decline.
By the same token, 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. Their low price-volatility may be a calm before a storm.
Risk reward trade-off
Optimizing Risk Adjusted Returns using the Sharpe Ratio does not optimize returns on a portfolio. The winning portfolio using Sharpe Ratios is the one with the highest score based on return and volatility. Some investors may prefer this if they don’t understand volatility.
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 main criticism of the Sharpe Ratio is that it is in error in using volatility as a measure of 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.
100% equities
My own approach is to invest in a concentrated portfolio of superb companies and hold them for the long term. I have occasionally invested in bonds. The last time was between 1998 and 2002. Since 2002 I have been 100% in equities.
I am not afraid of mathematics and statistics. My undergraduate university degree was a B.Sc. with a major in math and a minor in physics. That taught me about both the strengths and weaknesses of the application of math and statistics to investing.
Cliff Asness
Cliff Asness is a self-described Quant Investor. He is a Founder, Managing Principal and Chief Investment Officer at AQR Capital Management. AQR is a global investment management firm founded in 1998.
He is an active researcher and has authored articles on a variety of financial topics for many publications, including The Journal of Portfolio Management, Financial Analysts Journal, The Journal of Finance and The Journal of Financial Economics.
Cliff received a B.S. in economics from the Wharton School and a B.S. in engineering from the Moore School of Electrical Engineering at the University of Pennsylvania, graduating summa cum laude in both. He received an M.B.A. with high honors and a Ph.D. in finance from the University of Chicago.
Conclusion
There are different ways to skin a cat. Quant investing is one. If they do well with it, I wish quants well. For myself, I have never felt the need to quantify risk. I don’t think it can be done. I am content to live with an approach to assessing risk that is vaguely right rather than what I consider precisely wrong.
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Readers wishing to dig further into the subject of investment risk might take a look at these following posts:
The joy of higher return with no more risk
Many investors just don’t understand the risk/reward trade-off
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I’m also on Twitter @rodneylksmith
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