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Volatility is the best risk measure

Posted by Graeme in Business & Investment at 6:46 pm on Monday, 4 October 2010

I have just rewritten the Moneyterms article on volatility to cover common criticisms of volatility as a risk measure. The key points are that volatility makes intuitive sense when considered properly, correctly corrects for increased upside, and that the critics are unable to come up with a better measure.

The commonest critics seem to be fund managers, who would undoubtedly have an easier life if no one ever risk adjusted good absolute returns — and given the lack of alternatives, dropping the use of volatility would mean that. There are no real alternatives, even the Sharpe ratio is very similar in principle: it measures relative returns relative to the volatility of relative returns.

The attacks on volatility seem to be based on one of two things:

  1. The idea that a volatile security, or market, is a good buy when it is cheap, and,
  2. A failure to grasp that it measures the risk to expected returns.

The first of these is perfectly true, provided that you have identified a mis-priced security; provided that you are reasonably sure that the low price does not reflect the fundamental value of the security. It makes sense to dismiss the risk if you have proven your judgement through consistently good stock picking or market timing: if you are Warren Buffet. In fact, even the best investors spot relatively few such good opportunities. If you are that good, then you should achieve consistent out-performance, and therefore high returns without high volatility.

The second stems from a failure to grasp the effect of increasing the upside risk on the expected value. Suppose expectations for a security change because a possibility of a small chance of a huge increase in its value. That would increase its expected value, but this increase rests on a highly uncertain possibility, and this requires an adjustment to the risk measure.

Of course, so far I am talking about the standard deviation of expected returns. Volatility is the standard deviation of actual returns, and the obvious measure for measuring historical risk.

Volatility is a meaningful measure of risk, correctly reflects both downside and upside, and is mathematically tractable. Do you have a better idea?

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