Never confuse risk and volatility in investing

PUBLISHED : Saturday, 13 September, 2014, 4:47am

James Saft
Instead of reaping huge rewards, investors may end up with lower returns or even permanent loss of
capital if they ignore fundamentals
Of the many lazy and dangerous ways of thinking about investment, these two rank near the top: that
risk equates with volatility and that risk and rewards are a straight trade-off.
Both are overly simplistic and both lie at the heart of some of the most colossal errors in recent finance.
And while both contain large amounts of truth at their core, both concepts represent shorthand
versions of reality rather than tools that always, or even usually, work.
In financial theory, volatility is used more or less interchangeably with risk, something hedge fund giant
Howard Marks argues is mostly because volatility can be reduced to a number. That is useful when you
are trying to write an equation, publish a paper or defend a thesis, but amounts to a vast over-
simplification, one that threatens to put investors on a kind of auto pilot.
"In thinking about risk, we want to identify the thing that investors worry about and thus demand
compensation for bearing. I don't think most investors fear volatility," Marks wrote in a note.
"In fact, I've never heard anyone say 'the prospective return isn't high enough to warrant bearing all that
volatility'. What they fear is the possibility of permanent loss."
Now volatility, to be sure, can cause permanent loss because it can put investors in a situation where
they choose, or are forced, to crystallise losses by selling after a drop. And volatile securities tend to
suffer in price as a result, making them theoretically higher reward.
But volatility is only one source of permanent loss, and not even the most important, that being
fundamentals instead. Enron, for example, did not go belly-up because it was volatile, it was, near the
end, volatile because of the risk that it would go belly-up.
Unfortunately, volatility's ease of measurement has put it at the centre of risk management, leading to
all sorts of problems when, as in 2008, we get unprecedented volatility and correlation, leading to
permanent loss that was never predicted by the risk management systems and experts in charge.
That line of thinking leads in an almost direct line to another canard Marks takes after: that the riskier
the investment, the higher the reward.
While there is an upward slope in returns that correlates with risk, this is far from a mechanistic
relationship. Just because investors generally get paid to carry risk does not mean you, the individual,
will.
Risk, London Business School professor Elroy Dimson once wrote, "means more things can happen than
will happen".
Better instead to think of the risk-reward relationship as a pool that gets deeper the further out you
step. In the shallow, safer end, there are fewer things that can happen and lower rewards as a
consequence. As the water gets deeper, the range of outcomes broadens and includes the possibility of
drowning or, if you will, suffering permanent loss.
But even this pool is really a construct of investor perceptions. It does not have an actual measurable
sloping floor, only depth guesses painted on the side that represent what the market thinks the risks
may be.
One area that worries me is the way recent monetary policy has distorted our ability to detect risk.
Because central banks, for the very noble cause of protecting the economy, have reacted to sharp
market falls by easing policy, investors have been encouraged to see the stock market as a roller-coaster
ride.
While that popular metaphor well describes the stock market's ups and downs, it also presupposes that
there is a roller-coaster operator backed by engineers backstage somewhere.
It strikes me that one of the reasons we have been so long without a market correction is that
"everyone knows" that corrections do not last and the secret is not to sell. That has been an excellent
rule of thumb since 1998 or so, but it rather ignores fundamentals as a source of permanent loss of
capital.
Two outcomes seem likely as a result of this.
First, investors will pay less attention to fundamentals than they formerly did, trusting in policy to rescue
them if only they eat the magic risk pill in order to get the magic return. We are already seeing that,
especially in credit markets. The outcome of that is poor allocation of capital, lower economic growth
and, ultimately, lower investment returns, but over the long term.
The other outcome may take a while to arrive, but will do so suddenly and forcefully. At some point,
policymakers will choose, or be forced, not to backstop a downdraft in markets.
That implies a lot of volatility, leading not to higher returns but to permanent loss.












volatility usually refers to price fluctuations in a security, portfolio, or market segment during a fairly
short time perioda day, a month, a year. Such fluctuations are inevitable once you venture beyond
certificates of deposit, money market funds, or your passbook savings account. If youre not selling
anytime soon, volatility isnt a problem and can even be your friend, enabling you to buy more of a
security when its at a low ebb.
The most intuitive definition of risk, by contrast, is the chance that you wont be able to meet your
financial goals and obligations or that youll have to recalibrate your goals because your investment
kitty come up short.
In finance, volatility is a measure for variation of price of a financial instrument over time.
1. Finance: The possibility that an actual return on an investment will be lower than the
expected return.
2. The first rule of investing is to avoid the permanent loss of capital. Risk in the market is
different than volatility. It is essential to reduce exposure when risk is greatest: when investor
expectations are at or near their peak. There are many unknowns in the market, but our risk
management discipline is based on historical data and relies on observable and known facts.
Data supporting company valuation, consumer sentiment and investor expectations, is
essential for managing risk.
3. Outperforming the markets is difficult. The markets are complex, and emotions and
behaviors can wreak havoc with investors judgment. Fear of not meeting a particular goal
often pressures investors into accepting risk beyond their comfort zone. As quantitative
investors, we conduct objective research before forming a conclusion, and once formed, we
try to disprove the conclusion. We do know this:
4. Whenever it feels hardest to invest, history tells us it has been a whos who of good times to
invest. John Hussman, Hussman Funds
5. The greatest advantage, we believe, lies in understanding risks. It is difficult for investors to
embrace an investment process when their short-term focus causes them to become impatient
and abandon their discipline, obscuring their focus on long-term value.
The Fundamentals of Fundamentals
In the broadest terms, fundamental analysis involves looking at any data, besides
the trading patterns of the stock itself, which can be expected to impact the price
or perceived value of a stock. As the name implies, it means getting down to
basics. Unlike its cousin, technical analysis, which focuses only on the trading
and price history of a stock, fundamental analysis focuses on creating a portrait
of a company, identifying the intrinsic, or fundamental, value of its shares and
buying or selling the stock based on that information.
(For a more in-depth look at fundamental analysis, check out the Fundamental
Analysis Tutorial.)
Some of the indicators commonly used to assess company fundamentals
include:
cash flow
return on assets
conservative gearing
history of profit retention for funding future growth
soundness of capital management for the maximization of shareholder
earnings and returns















Never confuse risk and volatility in investing
Article in own Words
The Article is written by James Saft.
The investors ignores the fundamentals of investing in the
stock market this result in lower returns or permanent loss of
capital. In the broadest terms, fundamental analysis involves looking at any
data, besides the trading patterns of the stock itself, which can be expected to
impact the price or perceived value of a stock. Fundamental analysis focuses on
creating a portrait of a company, identifying the intrinsic, or fundamental, value of
its shares and buying or selling the stock based on that information.
Some of the indicators commonly used to assess company fundamentals
include:
cash flow
return on assets
conservative gearing
history of profit retention for funding future growth
soundness of capital management for the maximization of shareholder
earnings and returns
The two dangerous ways of thinking about investment are:
That risk equates with volatility
That risk and rewards are a straight trade-off.
These two ways of thinking are big mistakes in finance both are for short period.
The investor should use the fundamental analysis tools for investment describes
above.
Volatility is interchangeably used with risk but it is not the case. volatility is a
measure for variation of price of a financial instrument over time. Risk is the possibility that an actual
return on an investment will be lower than the expected return,thats why investor wants extra return
for bearing the risk. Volatility is up-and-down movement of the market. It's usually
measured by the standard deviation from the expectation. If you look at a day,
the movement is typically up, but not by very much. Any movement up or
down from its expectation is the volatility. volatility of a stock is the amount a stock is
likely to move away from the price at which it was traded at any given time.
Volatility can cause permanent loss of capital because higher volatility means that the share price
range is likely to be wider than the range for a low volatility stock. From an investors viewpoint this is
an important concept. Stocks that move by larger margins can be more profitable on the upside, but
also carry a greater risk of loss. In other words, volatility is a measure of risk.Thats why volatile
securities give higher rewards.

Volatility is only one source of permanent loss.

By diversification or pooling of investment the loss can be minimized/Higher risk is associated with
greater probability of higher return and lower risk with a greater probability of smaller return. This
trade off which an investor faces between risk and return while considering investment decisions is
called the risk return trade off.
While the Government through Central banks protect the economy from going down by funding the
market this will create problem in identifying the real risks of market.The investors like the Stock
market ups and downs because they earn in between ups and downs.But the fact that these ups and
downs have been created most of the time by the big market palyers who runs the market from
back.
Investors should concentrate on fundamental analysis before investing in the market.