Volatility Is Not Risk

For the long-term value investor, volatility is not risk. This is a very important concept in the investment business.

Many people, from analysts to aggregators of performance, from traders to teachers of corporate finance, use volatility as a stand-in for risk. Numerous conventional measures, such as the beta of a stock and the Sharpe ratio of an asset, incorporate the volatility of returns into the analysis of risk and “risk-adjusted” returns.

While it is possible that daily, monthly and annual volatility do look like risk to the short-term trader, they are irrelevant to the long-term investor. The same concept holds true when an investor is choosing a mutual fund or portfolio manager. Short-term volatility in returns should have no bearing on an assessment of long-term risk.

Once we are free from this faux definition of risk as volatility, our minds can focus on the real sources of risk. 

What are the economics of a business? What is the quality of governance? How leveraged is the company?  What is the threat from competition?

Answers to these questions are the real indicators of risk. This can’t be packaged in an elegant mathematical equation that gives one neat, standardised number as the answer. Yet it is better to be roughly right than exactly wrong.