Question: Are risk and volatility inseparable?

Question: Are risk and volatility inseparable?


According to the dictionary, a person or thing is volatile when it changes or varies easily and unpredictably. When it comes to a financial asset, its volatility or its standard deviation is a statistic that simply describes, using a number, the extent of price variations over time. In other words, the more volatile an asset, the faster and more extreme its unpredictable fluctuations.

"That morning, no one could imagine that John Appleseed would decide, instead of going to his office, to go to the mall with his AK-47 and for no apparent reason murder a dozen of his neighbors. Later, a friend of his tearfully commented to the news channel: "We don't understand what happened to him, he seemed so normal, so unvolatile..."

The adjective "descriptive" is key here, because volatility only gives us observable information about past price changes. It tells us nothing about the nature and risk of the underlying process that produces it. This distinction is critical and is often overlooked, misidentifying risk with volatility. The adjective "descriptive" is key here, because volatility only gives us observable information about past price changes. (See our article on the VIX: Volatility Index )

Risk is a difficult, complex and multidimensional concept. In contrast, volatility and other descriptive statistics are a comfortable attempt to reduce its many faces to a single number. As if the speedometer of the car gives us all the necessary information regarding the risk of driving. Even the AMF uses a risk scale between 1 and 7 based on volatility to rank FPs. Thus, a fund "1" presents practically no risk, and a fund "7" is very risky.

"Even the AMF uses a risk scale between 1 and 7 depending on volatility to classify investment funds... It makes no sense."

That does not make sense. If we imagine a fund that loses exactly -2.00% every month, its volatility according to the standard deviation formula would be zero (it has no volatility) and could be considered "risk 1" on the ladder. Perhaps by avoiding these contradictions, on the AMF site they get dirty and hide by saying that even if a fund is classified "1", it does not mean that it has no risk. But they don't explain why.

The volatility of the crocodile

Investors have taken hold of a low-volatility financial product. To better understand why it is a mistake to equate risk and volatility, let's take the example of the pelican and the crocodile. If we observe the quiet movement of a crocodile by the river for a long time, it transmits to us the information that there is no danger, that its movements are slow (low volatility) and that we can predict them. and easily adapt to it.

Thus, our friendly pelican can ask the crocodile to take him to the other end of the bank and hope that he will continue to behave as he has done so far. In this example, the pelican equates the crocodile's very low observable volatility with very low risk.

Why does the pelican think there is no danger? Because if we don't know its deep nature and only know its volatility (which is observable), the risk of not arriving safe and sound on the other side should be minimal. But everyone who knows the nature of the crocodile knows that there is a great and silent (unobservable) danger.

"Why does the pelican believe that there is no danger? Because if we do not know its deep nature and only know its volatility (which is observable), the risk of not arriving safe and sound on the other shore should be minimal."

Crocodiles move very slowly most of the time (they have very little volatility), but occasionally and unpredictably their behavior changes drastically: they move extraordinarily fast (much faster than their past volatility could even tell us imagine) to trap its trusting victim in its jaws. Therefore, mere empirical observation of the behavior of an asset, product or strategy (its history) is not sufficient to know the risks we face when investing.

The volatility of a fund or a product is not a good measure of risk, because it only tells us about the extent of its movements over time, and not about the nature and risks of these movements or on the direction that the underlying strategy may take. Risk is too complex and deep a concept to be reduced to a simple and comfortable number (for clients and quantitative analysts).

The volatility of a fund or product is not a good measure of risk, as it only tells us how big the movements are over time. The risk of investment funds and products lies in the nature of the underlying strategy, not in their volatility. There are very risky and non-volatile strategies (investment crocodiles). An extreme example is selling out-of-the-money options .

This options trading strategy produces positive monthly returns over long periods of time with near zero volatility, which makes them very easy to package and trade (its history of continuous increases without volatility, for example of around +1 % per month, sells very well). Eventually, a crash occurs in the markets causing the investor to lose, if not all, virtually everything they had previously invested and earned in the fund.

A stock market investment with high volatility, but harmless in the long term. On the other hand, there are very volatile and low-risk strategies, which we could call the Chihuahua investment in our zoo: They move a lot and make a lot of noise, but they are completely harmless.

The most commonplace example is investing in globally diversified stock exchanges through ETFs or low-cost funds, which is considered very risky due to its high volatility (we can temporarily lose half of investment), but which, in the long term, will bring us about twice the growth of world GDP. Paradoxically, it is risk-averse investors who renounce profitable and low-risk long-term investments, preferring low-volatility products that sometimes hide crocodiles.

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