Volatility Does Not Equal Risk

The mainstream media does a terrible job with analysis. No secrets there. However, some aspects of this incompetence are so fundamental to their basic duties as to be completely unforgivable. So it is with the abysmal failure by the media to distinguish between the totally separate concepts of “volatility” and “risk”. Indeed, so terrible is the performance by the media here that these two, separate concepts are often treated as virtual synonyms.

As always, the place to start with such analysis is definition of terms, with which the intellectually lazy mainstream media is usually too lazy to bother. Let's start with “risk”, since it is the simpler of the two concepts. In the context of investing, “risk” represents the probability that an asset which we bought and hold will (at some point) be sold for less than what it cost us.

There are two facets to such risk, however. Not only must we consider risk in the context of the basic probability that we might experience a “loss” on a particular asset, but the second aspect of risk of which we must be conscious is the potential magnitude of any loss. In very general terms, a low probability of incurring a large loss is something we need to guard against just as much as the high probability of incurring a small loss.

In looking at this “dual aspect” to risk, obviously what must be avoided at all costs are scenarios with a high probability of large losses. Conversely, we need not get especially concerned in scenarios where there is only a low probability of a small loss. Those are the basic dimensions of “risk”. Unfortunately, virtually the entire realm of business “journalism” regularly sabotages any discussion of risk by mixing-in issues of volatility.

Volatility refers to nothing more than the average magnitude of deviations from the mean. To put this into simpler terms, the more “volatile” the asset, the more wildly the price tends to bounce up and down. Over the long term, there is absolutely no connection or overlap between the concepts of risk and volatility.

Where the myopic media encounters its problems is that virtually none of these talking-heads ever looks at the “long term” picture of anything. Rather, they have been carefully conditioned over a period of many years to look only immediately behind themselves and/or at the ground immediately in front of their feet.

It is because the mainstream media is oblivious to “the long term” that it is utterly incapable of distinguishing between risk and volatility. Over the short term, while there is absolutely no causal connection between risk and volatility, “high volatility” tends to imply some degree of risk. Why is this?

Remembering our definitions, volatility is the size of “deviations from the mean”. Thus another way of describing a very volatile asset class would be to describe the movements in price as “erratic”. In the context of the shorter term, if we were ever forced to do our buying and selling over that time horizon then with any asset which moves erratically, at the time we went to sell it, it might have suffered a sudden plunge – leading us to suffer a loss.

At this point we need to introduce the mainstream media to “the long term”. Over the long term, volatility becomes totally irrelevant. Put another way, when we go to sell our long-term investment at some point in the future, it will not have mattered in the slightest whether the price moved from “A” to “B” in a smooth, steady line or whether it zig-zagged up and down like a seismograph.

Having now distinguished the two concepts, it is now possible to discuss them together (in an intelligent manner). When we combine the two, again we see a specific array of possible scenarios. There will be assets with high risk and low volatility. There will be assets with low risk and high volatility. There will be assets with low risk and low volatility. Lastly, there will be the dreaded asset classes with high risk and high volatility (i.e. your average Wall Street bank).

Looking at that array, it's quite obvious that asset classes with low risk and low volatility will be highly sought after – for “security”. Thanks to constant market-manipulation, automated trading algorithms, and markets populated almost entirely by schizophrenic lemmings there are no longer any asset classes with low risk and low volatility.