Investing: risk and volatility

In My Humble Opinion
1

One of my kids is taking investing for the future more seriously now. He used an online guide, Schwab Fidelity whatever, that had him fill out a questionnaire to help determine what mix fits his “risk tolerance.” He has has low risk tolerance so the guidance was pretty high bonds for his younger 30s age group.

Discussion I had with him, up for comment:

The guidance he received is lower volatility but volatility is not actually risk, not with a decent time horizon anyway. Over a three decade time horizon with regular contributions a higher equity portfolio is of little risk of major loss. It will bounce around along the way but the risk of being less than bond heavy at the end is very low.

IMHO the use of volatility as a synonym for risk is misleading to early investors. What is required is volatility tolerance not risk tolerance. And as we have shorter time horizons to needing to withdraw with have less ability to outlast volatility.

Thoughts?

2

I see what you mean about volatility having different meanings. Just a casual look at the definitions in regard to bonds vs stocks shows differences. I tend to read about it and read prospectuses and a few balance sheets but could never have talked with Louis Rukeyser on Wall Street Week.

3

Like you mentioned Doc, a long time horizon can give an investor time to recover from any losses. It’s so normal to have fluctuations over say 45 years.

4

This is exactly what I do for my day job, and I agree with you. I work adjacent to the investment industry in Europe (my fintech produces regulatory disclosure materials). If you market investment products (generally called PRIIPs, though certain types of products are excluded) here, you are required to produce an investor information document that includes standardized information, including figures that are computed according to defined formulae. One of these is the Summary Risk Indicator (SRI), which purports to reflect the product’s apparent risk, on a scale from 1 (low) to 7 (high). A large contributor to this figure is the historical volatility of the product (or a substitute equivalent product or index if insufficient history is available).

Risk, in a generalized sense, is basically impossible to state in an objective, quantified way. If it were possible to concretely measure and predict risk, then nobody would lose money, right? It seems to me, therefore, that a narrower view of risk is implied by its conflation with volatility. Rather than a broad prediction of how well the product will or won’t do over some arbitrarily long horizon, you can consider volatility in order to estimate the probability of the product being up or down at any particular point when you need to take your money out. If the product historically shows slow but steady growth, the risk of absorbing a loss at a given point is lower. But if it’s highly volatile, and you have a specific exit date, the chances are higher that the product will be down on that day.

This is not really “risk” in the way normal people think about it, of course, exactly as you say. But volatility can be measured, and our regulators want the investment companies to avoid squishy non-objective marketing-speak, so this is what we end up with, the least-bad of a range of not-good options. Even though it flies in the face of the legally mandated “past results are not a guarantee of future performance” language that appears in every prospectus, the PRIIP KID nevertheless uses past results to present what appears to the lay investor to be a prediction of future performance.

For those who are curious, the complex process by which the SRI and associated “performance scenarios” (i.e. “this is how the product might do over five years in a good market, or a down market, or a crisis market…”) are derived can be seen in this PDF document. It’s 35 pages of technical gobbledegook, so if you’re not in the industry, feel free to skim through just to get a flavor for the complexity imposed by the regulators. Starting on page 18, you can see the decision flows whereby the amount of history to be considered is determined, and then the brain-melting mathematics start a couple of pages later. It’s a whole lot of mandatory precision which is intended to lend an air of authority to something which is inherently imprecise and unknowable, but that’s how it’s done.

Obligatory caveat: This is of course specifically relevant to European regulation, but the mindset behind it is common in the broader industry.

So, yeah, I agree with what you’re saying, but maybe the above inside-baseball perspective will help you give your son some context and explain why things are the way they are.

5

Maybe not, but it’s certainly risk-adjacent. People make rash decisions in volatile markets, and they tend to throw out the “buy low sell high” mantra the moment the market hits a rough patch (or abnormally prosperous patch).

So if your son is self-aware enough to know that he’s at risk of liquidating his account the moment the bottom (temporarily) falls out, he’s wise to invest accordingly. He should also try to make this a temporary disposition, and educate himself further on the subject so that he becomes more comfortable with the market.

6

I find the “risk tolerance” questionnaire that seemingly 100% of these financial advisors give is pretty inane. It’s always presented in such a touchy-feely way, like, “If you see that you’re down 10% in a year are you going to panic and pull out all of your money, even if that’s not the objectively sensible thing to do”. Like the purpose is to manage your emotions rather than your wealth.

There are legitimate reasons to avoid volatility, like “I’m going to need this in two years, and I want to be sure that it’s not way down then”, but just not wanting to see it go down on some random thursday when the broader market is down is not one of them.

I occasionally get newsletter-type emails from my brokerage/bank talking about “market volatility”, but only when the market is down. Apparently big swings to the upside are not “volatility”. :slight_smile:

FWIW, I used to work a lot with “Implied Volatility”, which rather than looking at historical or projected behaviour of the price, looks at the options market for the underlying equity. So if something is trading at $100 but put options struck at $70 are trading at an elevated price, the market “expects” a drop, no matter what the historical behaviour is.

7

I’ve never gotten a questionnaire, but we had this conversation with our advisor. If they don’t understand your attitude on risk, they will assume one for you and that won’t go well.

As for volatility, you need to think of it for the entire portfolio as well as for individual investments. That’s what diversification is all about. A diversified portfolio is going to be less volatile than a stock in it.

8

I’d go with Warren Buffet’s advice: if you’re not willing to spend all your time on analysis and investigations, just use a low cost broad index fund.

I have dabbled in various investments over the last 30 years, including real estate and various high dividend stocks. Did a lot of number crunching and attempted ‘due diligence’ on the latter, trying to find hidden bargains. Which, in the end, weren’t.

And real estate has a lot of problems too (vacancy, repairs etc)… all the stuff that the ‘get rich quick’ courses don’t mention.

Backtesting, I would have been better off just putting everything into index funds.

9

It’s absolutely about managing emotions. People act incredibly irrationally all the time, and a very large part of an advisor’s job is to manage their clients’ expectations, their emotions and ultimately their behavior. Going through those inane questionnaires does seem silly at the time (“which of these three charts would you feel more comfortable having your money in?”) - but they are immensely helpful when the market shits the bed and the client calls up to cash it all out so they can bury it in the backyard next to Grandma. Being able to say, “remember when we walked through those questions before we opened your account, and we talked about market volatility and settled on a risk tolerance level? Today is why we did that - so we would have a plan in place for the long term so that the short term doesn’t dictate our actions.”

10

I always assumed these surveys were for the benefit of banks. So they could claim their results were compatible with client wishes or claim clients were sophisticated. Risk is hard to estimate, you can calculate a β value, which is often referred to (including in the link below) as “systemic risk”. Though I agree there are important difference and the goals and time horizons of investment matter greatly.

11

Absolutely correct - they’re a function of the compliance department to avoid any conflicts later down the road if a client wants to argue that a portfolio mix was too aggressive/conservative and lost too much money (or didn’t gain enough, depending).

12

As @Cervaise also discussed and pretty much the point: volatility is easier to measure so is used as a proxy for “risk” … but in fact it is a poor proxy for how many rank and file young investors should really be thinking about risk if they can maintain their plans over a long haul. It becomes a closer proxy as we get closer to needing to make withdrawals.

I’m not even convinced that bond funds are all that great in that sense? When we’ve had major stock market downturns bonds have seemed to crash too. They seem to be correlated and not independent and also at volatility risk in a recession.

With enough put aside I’d think as the time approaches we’d want to leave as much as possible in the index fund (or two) and have enough between income production (SS plus other income production) and uncorrelated assets (cash, even a bit of gold fund) to ride out a year or two of significant down market (to refill when the market goes back up)?

Or am I missing something?

13

I don’t think you are missing anything important, but I would like to point out that the volatility you measure is the past volatility, while the relevant volatility for the performance of the stock you own will be the future volatility, which is unknown. And even if it was known (which I insist it isn’t) it would make a big difference whether the volatility was high because the stock rose a lot or because the stock fell like a stone. And even a low volatility where your stock loses 0.1% of value every day is a very bad thing.
So, indeed, as you claim, volatility is a substitute for risk, but a lazy and inherently flawed one. This shows that future risk is simply unknowable. This is true for investments and for all other realms of life. But we can use proxies that often work reasonably well, at least in normal circumstances. Unfortunately they tend to break down when we need them the most! And we fall for tricks that seem to work well, but don’t, like superstitions.

14

I think volatility is an important component of financial risk. It’s not the only component. Inflation is a serious risk to someone contemplating retirement, too. So is, “the company holding your funds goes bankrupt and loses the information to link you to your money”. (Not a major risk with the big brokerage firms, but it’s come up with some blockchain investments, and i think it’s worth considering.)

I had similar concerns as an actuary. I did a lot of reserving, which means i tried to estimate how much money my employer would have to pay in the future on policies sold in the past. (My last position was reserving asbestos liability and i was literally estimating how much money my employer would pay in the future for policies sold in the 1960s. And it was a big number.)

We often estimated volatility is our estimates. And that’s not totally meaningless. But the big movements, the ones that threaten the health of an insurance company, didn’t come from volatility. They come from Congress signing Superfund legislation (which retroactively created liability on policies sold in the past) or from a company underpricing its product and selling way too much of it at a loss. Or from inflation, which is a big deal for insurance companies, too. (Most companies make a product and then try to sell it. Insurance is sold upfront, and the “product” is “made” later as claims are paid at prevailing prices.)

So i was always trying to look for what the real risks to my employer’s both line were, and those weren’t typically volatility.

15

If he is not an expert in financial trading then do not try it.

Put your money in an index fund or with a financial advisor (many banks have them) and let them deal with it. Loads of people do that and they get good returns. Occasionally great returns. And occasionally bad returns…there is risk.

Chances are those will provide better returns than trying to figure it all out for yourself unless you (general “you”) mean to make this a focus of your life and study it closely…really closely…daily and hourly. Even then you will probably lose.

FWIW…there are low volatility indexes out there. Lots of ways to make money whatever volatility is doing.

16

Yeah trading himself is not on the table for him. It is putting lots in bond fund rather than the stocks index fund(s). And add on discussion related to dealing with prediction of future risk of volatility as the time of needing the money gets closer.

For myself I’ve always had a small portion as “self-directed” but that is more to play. If I do as well as the index I feel it is a win. It is after there is enough otherwise in the funds basket.

But yeah going forward I also for myself wonder about the advised shift to higher and higher bonds as the means to protect from large market volatility risk even as retirement gets closer.

17

The first risk is your financial advisor. I see that there is a strong consumer push in the States to have retirement advisors be fiduciaries. This is really smart, has been and will obviously continue to be opposed, and should be done in Canada too. (Odd Biden supports this and Trump didn’t). If the advice you receive is not the best independent advice, there is increased risk from the beginning.

Future risk and volatility are poorly estimated by past risk and volatility. But what else do you have? The problem with things you can measure and quantify is that they are given excessive importance because you can measure and quantify them. I am persuaded a lot of what MBAs learn is because there is a simplified mathematical approach to some topics.

The market might go up and down any year. An elderly person might not have enough time for the market to recover from a loss, and so high rate GICs might be more suitable for one person than other.

There is something to be said about Taleb’s barbell approach. 90%-95% of your income in low cost index funds and diversified by industry, blue chip and dividends. Low cost, conservative investments paying well above inflation. 5%-10% in higher risk stocks that have tremendous potential. Not cryptocurrency scams or prospectuses that use trendy lingo more like the next AI, or something smrt like Trump Social that will rocket to the moon, baby!!!

18

Broadly speaking I have been advised by my broker to be a little more aggressive investing when younger and get more conservative as you get older (start making your investments safer so you can count on them). Even then the line is not dramatic (unless you really want to bet it all on a few rolls of the dice so-to-speak).

Using a little money on Robinhood to do your own investing is fine but you’d probably make more if that was invested with your financial advisor. But have fun if it doesn’t matter too much. I see Robinhood like Vegas. If you win you think you are smart and invest more but, in the end, the house will win every time (i.e. you lose).

19

Yeah that advice is the crux here. My son being I think very conservative for his age, and what actually serves as conservative as we approach retirement age. Is being much higher in bonds actually a great or the best conservative approach? Or is it better to stay in stocks with enough otherwise on hand to wait out a market downturn but being somewhat confident that the funds will recover and do better over the moderate term?

20

But for a stock with a liquid options market, you can have implied volatility, which is neither past nor future volatility, but the current cost of hedging against volatility. And it’s the type of volatility you can do something about – by buying/selling options to hedge that risk,

E.g. if you’re holding a stock priced at $100 and also buy a put at $80, you’ve eliminated the risk (for yourself) of the price dropping below $80 by selling that risk to someone else. And there’s not really a better measure of how risky an event is than how much the market will charge to take that risk away.

I think that is the important part. Over a long enough time horizon, stocks will outperform bonds. By being overly concentrated in bonds your son is forgoing return to avoid the risk of a short-term loss.

In a perfectly rational world, people would feel the same about “I lost $10000” and “I could have had an extra $10000, but missed the opportunity”, but in the real world usually people feel much worse about the former than the latter, so tend invest more conservatively than they should so they can avoid the loss at the expense of the gain.

(And I think that those risk tolerance questionaries exacerbate that asymmetry in perception instead of correcting it. After all, a client is more likely to cause a stink if they lose money than they are if they get a return, but a smaller one than they could have gotten.)