Field of Play
And they don’t know any other way
Since about 1952 it has generally been accepted in academia and the investment industry that volatility is a good proxy for risk. From that it is taken that if you want to measure risk you simply have to measure volatility. And, if you want to manage risk, it is thought that you can do so through measuring volatility. The argument continues, you can control risk by controlling volatility. Also, it is said that while you cannot increase rewards i.e. returns without increasing risk, you can increase risk adjusted returns by diversification. And the way you measure risk adjusted returns is by measuring volatility. And the way you measure volatility is by calculating the standard deviation of your price data series.
Before we go too far with these thoughts, let’s see what Warren Buffett thinks about volatility as a measure of 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.”
Sharpe Ratio
The Sharpe Ratio is used to measure the performance of money managers or of the so-called Risk Adjusted Return (RAR) of any portfolio. 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) p48
There are several problems with the Sharpe Ratio. First there is the assumption that the stock market is efficient. Second, is the assumption that volatility is a measure of risk or a reasonable proxy for measuring risk. 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.
My discount brokerage provider used to have an investor community designed to allow the brokerage clients to exchange ideas using pseudonyms. The service allowed one to look at the Risk Adjusted Returns (RAR) 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 RAR 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 much greater than that of the S&P/TSX Composite.
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 initial criticism of the Sharpe Ratio is that it is 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.
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 equating 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.
Last word to Warren Buffett
I want to give the last word on this topic to Warren Buffett. This is from an article in the February 27, 2012 issue of Fortune. As posted in CNN Money as CNN Money article . The article is titled: Why stocks beat gold and bonds. Buffett says:
“Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire Hathaway (BRKA) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power — after taxes have been paid on nominal gains — in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.
From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a nonfluctuating asset can be laden with risk.” (Emphasis Added)
Conclusion
The stock market does contain risks. But we don’t have to accept that to earn a higher return we must undergo higher risks. When we look at the investment styles of the great investors like Warren Buffett, we see that a higher return can be obtained without taking on higher risks. This is accomplished by sound principles of operation, a sound investment process. Volatility is not risk, nor does it measure or act as a proxy for risk. Volatility is as normal as a succession of sunny and rainy, even stormy, days. We accept this. We don’t run away from it. We take advantage of it if we can.
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Readers wishing to dig deeper into the topic of risk and investing might take a look at the following posts:
The joy of higher return with no more risk
Many investors just don’t understand the risk/reward trade-off
The price of risk in equity markets
Sentiment and the four faces of risk
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