The problem with volatility
The<![if !vml]><![endif]>financial services industry focuses primarily on volatility when assessing investors’ aversion to risk because most retail portfolio construction uses this risk alone when constructing portfolios.
There are problems of focussing on volatility as single measure of risk.
Volatility tells you how risky on average an investment has been over time but nothing about how risky an investment is at a moment in time.
The biggest risks actually occur when investments are over valued. Volatility is not a measure of value or price.
The risk of up and down movements reduces over time. If you hold your investments for long periods of time, the actual risk of these up and down movements becomes negligible.
The graph below shows the how the risk of investing in the stock market reduces over time. The black line is the US stock market as measured by the S&P 500. It shows the monthly movements of the market and explains why most investors are concerned about up and down movements over short periods of time. However, if you are prepared to hold your investments for at least 5 years, the red line is the actually historical risk to the value of your investment. This line is much smoother and is the line investors should focus on. <![if !vml]><![endif]>
The biggest risk to an investor is the risk of a prolonged and severe decline in the market. This is not measured by volatility. Volatility is a monthly risk, the risk which investors need to be protected against may last many years.
Most risk assessment falsely leads investors into assuming that by accepting the risk of larger price movement they will receive a higher return. Higher risk is just as likely to translate into greater loss as opposed to higher return.
Volatility does not tell you how to structure a portfolio to meet financial needs. A properly constructed portfolio should shield any investor from the risks of volatility.
Volatility is a consequence risk of an investment style and the style’s current strategy. It is a natural investment risk and providing allocation and valuation are managed properly, need not affect a client’s financial security.
For further information on risk see risk profiling and risk assessment in the Education section and the weaknesses of retail risk assessment and modern portfolio theory in the technical section..