Volatility is not risk

David MoonBlog

by David Moon

Assessing risk is a useful life skill that people develop and hone over their lives. We eventually learn not to approach crazed dogs, or spray an entire bottle of cologne on our four-year-old brother. Yet when it comes to using those same risk assessment tools to choose a 401(k) investment, people will lose their sensibilities and make decisions they never make when buying a lawnmower.

Part of the problem is that people generally get emotional when significant money is involved. Folks get emotional about their 401(k) in a way they seldom do with their garden tools.

The investment industry doesn’t help much. It has adopted a definition of risk that is sophisticated, measurable, precise—and functionally ludicrous.

About forty years ago, academicians, then advisers and consultants, began telling people that volatility in an asset’s price equated to risk. If the price of two stocks increased from $7 to 10 a share over the course of a year, but one of the stocks bounced around more than the other, the more volatile stock was deemed to be more risky.

It wasn’t hard to sell the investment industry on this concept. Using formulas most people forget two weeks following their final statistics exam, investment consultants began using things like standard deviation, variance, co-variance and beta to “measure” risk.

These statistical definitions of risk offer an intimidating level of detail, creating the appearance of sophisticated expertise. Of course, research repeatedly shows that liars are extremely generous with details.

When U.K. voters chose to leave the European Union, the Dow Jones Industrial Average collapsed 948 points in two days. Four days later it had enjoyed its best performing week of 2016. The only risk that existed during those 7 days would have been if you had sold when the market was down—and that would have been a self-inflicted risk.

Once someone tells you that price volatility equals risk, their next comment is usually “the only way to make higher returns is to take on more risk.”

Even using their silly definition of risk that isn’t true.

Using beta (a common industry definition) as a proxy for risk, in the past three years the most risky stocks in the S&P 500 performed significantly worse than less risky stocks. The 260 stocks with betas less than 1 increased an average of 49 percent since June 2013; the 240 stocks with betas greater than 1 increased 36 percent.

And beta had nothing to do with the return of either group.

Any old man at an equipment or real estate auction knows that risk is the chance you’re going to lose money on an investment. It can’t be objectively calculated, but it can be subjectively estimated. No prospective buyer ever asked for the standard deviation of an apartment building or the beta of a used bulldozer.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).