Why is volatility risky?
A bit of theory for you. Modern Portfolio Theory states that markets are efficient, and that returns can be explained by risks. The most common definition of risk is volatility (or beta). [1]
I’ve never been comfortable with the idea of volatility, and only volatility, as risk. It just doesn’t sit right with me. It seems that volatility is only risky over the short term - if something fluctuates wildly on a rapid upward ascent, is it really risky? And aren’t there are other forms of risk, like the risk of underperforming over the long run or the risk of not having enough money available when you need it?
So while I don’t think that volatility = risk and risk = volatility, there is some relationship between risk and volatility.
Specifically, I think there are two ways in which volatility is risk.
First, volatility is risky if you will be withdrawing from your portfolio. If an asset is volatile, and you need to sell it when it is down because you need the cash, then you’ve just lost money.
This especially applies when you’re nearing retirement; if a volatile 50% of your porftolio decides to take a 10-year dip when you turn 70, it doesn’t matter if it’s going to be dramatically up during the following 10 years - you’re selling an investment low.
But it is a risk even if you’re 40. What if you lose your job and have to draw upon your investments? Or what if you have unexpected medical expenses?
Second, volatility increases the risk of tracking error, which is a behavioral risk. If I hold an asset that fluctuates wildly, and it is down significantly (especially compared to some benchmark), I may decide that it is a dog and sell it. This is a risk that I will make a bad decision, worrying about the short-term performance of an investment rather than sticking it out for the long term
Each of those is a legitimiate risk. But beyond that, call me a MPT heretic, but volatility just doesn’t seem that risky. If you told me that an asset would swing wildly but have great long-term performance, I would call it less risky than a non-volatile stock that may or may not make money.
[1] MPT deals with non-diversifiable risk. You can take a big risk by not diversifying, e.g. only buying one stock. But this risk can be removed by diversifying - e.g. holding a basket of 50 stocks, or a mutual fund, or an index fund.
