(Reuters) - Of the many lazy and dangerous ways of thinking about investment these two rank near the top: that risk equates with volatility and that risk and rewards are a straight tradeoff.
Both are overly simplistic and both lie at the heart of some of the most colossal errors in recent finance. And while both contain large amounts of truth at their core, both concepts represent shorthand versions of reality rather than tools which always, or even usually, work.
In financial theory, volatility, the amount a security goes up and down in price, is used more or less interchangeably with risk, something hedge fund giant Howard Marks argues is mostly because volatility can be reduced to a number.
hat’s useful when you are trying to write an equation, publish a paper or defend a thesis, but amounts to a vast over-simplification, one which threatens to put investors on a kind of auto pilot.
“In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility,” Marks wrote in a note to clients sent last week.
“In fact, I’ve never heard anyone say, ‘The prospective return isn’t high enough to warrant bearing all that volatility.’ What they fear is the possibility of permanent loss.”
Now volatility, to be sure, can cause permanent loss, because it can put investors in a situation where they choose, or are forced, to crystallize losses by selling after a drop. And volatile securities tend to suffer in price as a result, making them theoretically higher reward.
But volatility is only one source of permanent loss, and not even the most important, that being instead fundamentals. Enron, for example, didn’t go belly up because it was volatile, it was, near the end, volatile because of the risk it would go belly up.
Unfortunately, volatility’s ease of measurement has put it at the center of risk management, leading to all sorts of problems when, as in 2008, we get unprecedented volatility and correlation, leading to permanent loss which was never predicted by the risk management systems and experts in charge.
That line of thinking leads in an almost direct line to another canard Marks takes after in his letter: that the riskier the investment the higher the reward.
While there is an upward slope in returns which correlates with risk, this is far from a mechanistic relationship. Just because investors generally get paid to carry risk doesn’t mean that you, the individual, will.
Risk, London Business School professor Elroy Dimson once wrote, “means more things can happen than will happen.”
Better instead to think of the risk/reward relationship as a pool which gets deeper the further out you step. In the shallow, safer end there are fewer things that can happen and lower rewards as a consequence. As the water gets deeper, the range of outcomes broadens and includes the possibility of drowning, or, if you will, suffering permanent loss.
But even this pool is really a construct of investor perceptions. It doesn’t have an actual measurable sloping floor, only depth guesses painted on the side which represent what the market thinks the risks may be.
One area which worries me is the way recent monetary policy has distorted our ability to detect risk. Because central banks, for the very noble cause of protecting the economy, have reacted to sharp market falls by easing policy, investors have been encouraged to see the stock market as a roller-coaster ride.
While that popular metaphor well describes the stock market’s ups and downs, it also presupposes that there is a roller-coaster operator backed by engineers backstage somewhere.
It strikes me that one of the reasons we’ve been so long without a stock market correction is that ‘everyone knows’ that corrections don’t last and the secret is not to sell. That’s been an excellent rule of thumb since 1998 or so, but it rather ignores fundamentals as a source of permanent loss of capital.
Two outcomes seem likely as a result of this.
First, investors will pay less attention to fundamentals than they formerly did, trusting in policy to rescue them if only they eat the magic risk pill in order to get the magic return. We are already seeing that, especially in credit markets. The outcome of that is poor allocation of capital, lower economic growth, and ultimately lower investment returns, but over the long term.
The other outcome may take a while to arrive, but will do so suddenly and forcefully. At some point policy makers will choose, or be forced, not to backstop a downdraft in markets.
That implies a lot of volatility, leading not to higher returns but to permanent loss.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com and find more columns at blogs.reuters.com/james-saft)
Editing by James Dalgleish