Today’s Advisors and Investors Do Not Equate Risk and VolatilityAdvice to the Advisor
By the 1990s, forty years after Harry Markowitz had introduced his Modern Portfolio Theory, the concept of risk avoidance had gained enormous influence in the world of portfolio management. Computer programs had come into being plotting different investment mixes into an “efficient frontier,” causing many financial professionals to equate risk and volatility.
Michael Keppler, then First VP of Commerzbank Capital Markets in New York, viewed this development with concern, questioning Modern Portfolio Theory’s use of volatility as a proxy for risk. Modern portfolio theorists, Keppler stated, do not define risk as a likelihood of loss, but as volatility, which is determined using statistical measures of variance. In a white paper published in the banking industry journal Die Bank, Keppler stressed that “volatility, in other words, is essentially a double-edged sword, and does not measure what an investor intuitively perceives as risk.” In a rising market, he emphasized, high volatility can boost the return potential of an investment.
As financial advisors, we learn daily that value means different things to different people. Therefore risk (the possibility of losing something of value) also means different things to different clients. For many decades, investors defined risk as the chance of permanent loss of capital. Wherever there was volatility in the price of an investment, that meant there was risk. Today, just as Keppler was insisting three decades ago, investors need to ask themselves—are risk and volatility really the same?
In fact, as Sheaff Brock Director Jim Murphy explains, understanding the difference between market volatility and market risk is a key skill for investors to have. Advisors can—and should—guide clients to an understanding of that difference:
Volatility is how rapidly or severely the price of an investment may change, while risk is the probability that an investment will result in permanent loss of capital.
In 2007, Goldman Sachs went on record as stating that index volatility should be considered an asset class in itself, offering diversification and the possibility of investment return.
Significantly, Sheaff Brock presents volatility and risk as two distinct and separate elements in portfolio management. Our proprietary strategies strive to meet your specific needs for income and/or growth while also reducing volatility and risk.
In Sheaff Brock’s thinking, investors put themselves at a disadvantage by equating risk and volatility. If investors choose to do all they can to avoid both risk and volatility, they will typically pay some price through lower returns. Alternately, they can differentiate between the two, adopting strategies that may prudently profit from volatility.
Today’s advisors and investors do not equate risk and volatility.