One modern portfolio theory (MPT) pillar that is unquestionably broken is the use of volatility, specifically standard deviation, as a measure of risk. This initial error in MPT’s development is a major contributor to active investment management underperformance.
Volatility Is Not Risk
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 volatility, or the bumpiness of the ride.
Various dictionary definitions of risk converge on something like the “chance of loss.”
- Noun: exposure to the chance of injury or loss; a hazard or dangerous chance.
- Insurance: the degree of probability of such loss.
- Verb: to expose to the chance of injury or loss; hazard.
Not a single definition includes volatility as a part of its explanation. Dictionary definitions and popular understandings of risk might differ from a business definition, yet a popular business dictionary describes over a dozen different forms of risk, ranging from exchange rate risk to unsystematic risk, all of which focus on the chance of permanent loss.
The insurance business relies on an understanding of risk, and an insurance licensing tutorial by Kaplan University says that “risk means the same thing in insurance that it does in everyday language. Risk is the chance or uncertainty of loss.”
Only finance defines risk as short-term volatility. Why? In the 1950s, academics recognized that hundreds of years of statistics-research thinking could be borrowed to analyze the performance of investment portfolios — if some of the definitions could be bent to their aims. Once standard deviation was transformed into “risk,” the work of analyzing portfolios could begin and theories could be developed.
The Origins of This Misconception
In his seminal 1952 Journal of Finance paper, “Portfolio Selection,” Harry Markowitz said, “V (variance) is the average squared deviation of Y from its expected value. V is a commonly used measure of dispersion.”
He continued: “We next consider the rule that the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing. … We illustrate geometrically relations between beliefs and choice of portfolio according to the ‘expected returns — variance of returns’ rule.”
Whoa, hold on a second! Investors do want variance of return, and to the upside. Not only that, how did a blithe proposition regarding a statistical calculation turn into a rule in less than a paragraph? As Markowitz then stated, again blithely, “[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.”
This sentence creates a major problem for how investment managers are currently evaluated. When investment product distributors prefer “maximum return versus minimum variance,” then closet indexing is not far behind.
Markowitz is borrowing on hundreds of years of statistical theory to make an important point: Diversification can lead to better outcomes in investing. But to make the leap to volatility and its close cousin, beta, as risk measures, as much of the industry has done, is an egregious mistake.
Volatility Is Emotions
Nobel laureate Robert Shiller showed that stock prices fluctuate much more than the underlying dividends, the source of value, in his seminal paper. The implication is that stock price changes are largely driven by something other than changing fundamentals. Volatility is the result of investors’ collective emotional decisions. Shiller’s contention has withstood the test of time. Numerous studies have attempted and failed to dislodge it.
So not only does volatility capture both undesirable down price movements along with desirable up movements, it is mostly driven by the collective emotions of investors and has little to do with fundamental risks. Since emotions are transitory and much of the resulting effect can be diversified away over time, volatility fails as a risk measure.
Finally, some maintain that since investors enter and exit funds based on strong short-term upsurges and short-term drawdowns, volatility represents business risk for the fund. But why should fund business risk be intertwined with investment risk? There need to be separate measures since the risk faced by investors and funds is distinctly different.