Rethinking the Relationship Between Volatility and Risk

Julian Koski, Co-Founder and Chief Investment Officer, New Age Alpha
Nov 7, 2019 1:55:06 PM 3 min read
I think too many investors and analysts equate stock market risk with the volatility of a stock’s historical returns and nothing else. There is far more to risk than that, and this is often easy to see. Sometimes stock valuations are so high that you can’t help but feel you are taking too much risk by investing in them. After all, the more you wager, the more you stand to lose. If I buy a stock for zero, I am taking zero risks. On the other end of the theoretical spectrum, if I pay an infinitely high price for a stock, I am taking an infinite amount of risk.

This is true regardless of how volatile the stock’s returns have historically been. In fact, many wise investors may argue that higher volatility actually reduces risk, because that volatility will allow the investor to time purchases better. This is particularly true when the investor has a long-time horizon and doesn't need to be concerned with daily, weekly or monthly fluctuations in price. This is because really, I feel, the only downside to volatility is that, if forced to sell, I might be forced to sell when the stock happens to be on a downswing. 

So, if I have a one-year horizon, and I will be forced to sell on a particular day, volatility does introduce an element of risk. But if I have flexibility in choosing when to sell, or if I own a security I never intend to sell, volatility as a measure of risk seems a bit inappropriate.

Is volatility a crutch?

Why, then, do so many analysts and investors insist that volatility or its derivatives (beta, standard deviation, etc.)  are how we should make investment decisions? I argue it is a combination of laziness and having no better ideas. In a mathematical framework, volatility is beautiful. It is easily calculated and definite. To know how risky a stock is, all one need do is observe historical returns. And then risk can be boiled down to a single number. 

At the same time, risk is a very elusive concept and exceptionally difficult to measure objectively. We all know it is riskier to drive a car at 80 miles per hour than 30 miles per hour. But how much riskier? How can we quantify something non-quantitative?  How much should we be compensated for taking this extra risk? These are the types of questions finance researchers have been grappling with for decades. On the other hand, volatility is a convenient, albeit simplistic, solution. And thus, it has been widely adopted.

The key to success: Avoiding the losers

Of course, the real risk of investing in financial assets is the risk of losing. And I will concede that volatility is risky when the returns are low (or negative). That is what I am trying to avoid. But when volatility is measured merely as the dispersion of returns, and not whether they are above or below some standard, it just seems silly to suggest a stock is riskier for that reason alone. What matters to me is the price I pay and whether I pay too much for the performance the company will deliver.

Oftentimes with stocks, this means that the humans making investing decisions have pushed the stock price too high relative to management’s ability to deliver results. This is what we at New Age Alpha call The H-Factor. By balancing price and value, The H-Factor describes risk only after considering the price paid. 

CC: NAA10021

Julian
Kern
Co-Written by Julian Koski, Co-Founder and Chief Investment Officer and Andy Kern, Senior Portfolio Manager