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Risk = Volatility Only in Finance<\/strong><\/p>\n The concept of volatility as risk rests on a critical assumption that is overlooked by most of the industry: Only in finance is risk defined as\u00a0volatility. Dictionary definitions of risk<\/a>\u00a0have as their center of gravity, something like the \u201cchance of loss.\u201d For example:<\/p>\n Surely you notice that not a single definition includes volatility as a part of the meaning of risk. You might say, \u201cYeah, that\u2019s great but dictionary definitions and popular understandings of risk might differ from a business definition.\u201d But a popular business dictionary from Barron\u2019s describes over a dozen\u00a0different forms of risk, ranging from\u00a0exchange rate risk\u00a0to\u00a0unsystematic risk, all of which focus on the chance of permanent loss. Where\u2019s volatility? Nowhere to be found.<\/p>\n Risk is central to the concerns of investors, but not the way it is in the very business whose entire operations are obsessed with it, the insurance business. These are some of the oldest enterprises on the planet and they are worth hundreds of billions of dollars. They must have a hyper-refined understanding of risk in order to be a going concern, and for several centuries. Yet, an insurance licensing tutorial\u00a0says that \u201cRisk means the same thing in insurance that it does in everyday language. Risk is the chance or uncertainty of loss.\u201d<\/p>\n Only finance equates risk with volatility. Isn\u2019t this peculiar? Why? How?<\/p>\n <\/p>\n I would love it if you would receive notification of my new articles \u2013 sign up here<\/strong><\/a> \ud83d\ude42 Don\u2019t forget to comment on the article in the space below. Thanks!<\/p>\n <\/p>\n Risk = Volatility Origin Story<\/strong><\/p>\n In\u00a01952, Harry Markowitz argued that investment portfolios should optimize expected return relative to volatility<\/a>. In \u201cPortfolio Selection\u201d risk is directly associated with volatility and as measured by the variance of return. Markowitz states, \u201cV (variance) is the average squared deviation of Y from its expected value. V is a commonly used measure of dispersion.\u201d He then continues to say:<\/p>\n We next consider the rule that the investor does (or should) consider expected return a desirable thing\u00a0and\u00a0variance of return an undesirable thing. . . We illustrate geometrically relations between beliefs and choice of portfolio according to the \u2018expected returns \u2014 variance of returns\u2019 rule.<\/em><\/p>\n Whoa, did you catch what just happened there? Investors\u00a0do<\/em>\u00a0want variance of return, and to the upside. Right? Yet, Markowitz states, \u201cthe rule that the investor does consider\u2026variance of return an undesirable thing.\u201d Not only that, how did a blithe proposition regarding a statistical calculation when he was discussing \u201cV (variance)\u201d turn into a \u201crule\u201d in less than a paragraph? Markowitz then states, again a bit blithely, \u201c[This rule] assumes that there is a portfolio which gives both maximum expected return and minimum variance, and it commends this portfolio to the investor.\u201d<\/p>\n Sadly, this sentence is the source of tremendous misunderstanding: risk \u2260 volatility. Ugh!<\/p>\n <\/p>\n We Live in a CAPM World<\/strong><\/p>\n This philosophical screwup creates a major problem for how investment managers are currently evaluated. Markowitz is the basis for the belief asset allocation is the most important consideration when seeking the maximum return for a given amount of volatility. Because his work was seen not just as a philosophical treatise, but also as a tool, the investment industry still seeks efficient frontiers made up of \u201ca portfolio which gives maximum expected return and minimum variance.\u201d<\/p>\n It is not minimum variance that investors want! It should go without saying they want maximum upside relative to downside, or in other words, large outperformance that offsets smaller underperformance. Sadly, though, mean-variance frontiers became the first pillar of modern portfolio theory (Capital Asset Pricing Model and Efficient Market Hypothesis being the other two). In fact, the positive correlation of risk and return is a paramount assumption in CAPM.<\/p>\n In other words, this idea lies at the heart of two of three pillars of a modern portfolio theory. Thus, if it is demonstrated that the risk = volatility connection is spurious then we should also have confidence in rejecting MPT.<\/p>\n <\/p>\n There is No Evidence<\/strong><\/p>\n The powerful prediction that beta, as a measure of risk, has a positive relationship with expected returns was challenged by Irwin Friend and Marshall Blume just a few years after the CAPM was first proposed<\/a>. Based on a sample of 200 portfolios using monthly returns from 1960-1968, they conclude:<\/p>\n <\/p>\n\n
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