Volatility Does Not Equal Risk

I don’t easily go about criticizing Finance Blogger King Felix Salmon (especially after he said such nice things about me), but I have to speak up when he equates volatility with risk. Felix says that stocks aren’t a good buy and adds that “when an asset class gets more volatile, it gets riskier.”
Hmmm. Let’s take a step back. Risk is a very peculiar concept in finance. The problem is that we use this one word “risk” to describe many different things. What does risk mean? Well, you can take your pick. There’s the risk of what you don’t know. There’s systemic risk. There’s the risk that you won’t do as well as everybody else. There’s the risk that you’ll lose everything. The list of risks goes on and on.
Gold is a good case study on which to contemplate the meaning of risk. Gold is popular with goldbugs because it’s the least risky investment possible. In this sense, we’re defining risk as an investment losing its inherent value. In other words, gold can’t go bankrupt. Governments? Sure, they go belly up all the time, but even in our Mad Max future, gold will still be around.
But in another sense of the word risk, gold is highly risky. Gold tends to be very volatile. It bounces up a lot each day. On the other hand, gold tends to have a very low, and even negative, beta. So which is it? Is gold risky or not? It really depends on the kind of risk you’re talking about.
My point is that there’s no evidence that greater equity volatility leads to poorer performance. The risk of a market plunge is the kind of risk that matters. Except at very low levels, the historical evidence is that volatility doesn’t much affect future returns. Only when the VIX gets down below 13 does that market show some outperformance.
I know it seems counter-intuitive but volatility does not equal danger.

Posted by on May 11th, 2010 at 12:36 pm


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