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Is volatility a true measure of risk? That was the age-old question that Wong Kok Hoi, CFA, founder and chief investment officer of APS Asset Management, put to delegates at the 66th CFA Institute Annual Conference. His answer? “I don’t think so. There is insufficient evidence to back it up.” Wong noted that there are plenty of risk measurement concepts available to financial professionals — volatility, beta, value at risk (VaR), to name just a few — yet there is a disconnect between theory and our ability to detect risk. “With these concepts around, why have we fund managers done so consistently poorly in our attempts to identify potential risks?”
Wong noted that, according to modern portfolio theory (MPT), the higher the volatility, the riskier the security. “Over the last 30 years or so, there has been a debate about whether or not MPT resonates with market behavior. While the verdict is still out, we fund managers have been using it.” (For more on this topic, read “Modern Portfolio Theory: Bruised, Broken, Misunderstood, Misapplied?”)
Wong pointed out that in the United States, in the run-up to the downturn that swept through the markets in 2008, there was low volatility, “but the U.S. stock market experienced one of the most savage bear markets [and thus] the low volatility from 2005 to 2008 gave investors a false sense of safety.”
Wong said MPT “failed miserably” in the United States. But its failure was not just in North America. He also cited the example of Japan. “Interestingly, the Japanese stock market was also characterized by low volatility in the five years preceding the peak in December 1989. Not only did it drop 40% in 1990, it went into a 22-year bear market, the longest bear market in post-war history,” Wong said. “Needless to say, adherents of MPT have had their faith shaken beyond repair.”
Volatility “at best describes past behavior, nothing more,” Wong contended. “It’s like driving a car; the rearview mirror tells you little of what lies ahead. Volatility provides you with absolutely no proof whether the senior management is competent or has integrity. You have no idea whether the business franchise is strong, or whether the stock is priced relative to underlying revenue and so on. . . . If it gives us little idea of what lies ahead, why do we still use it as a measure of risk? What purpose does it serve?”
Wong went on to point out that “the three investment gurus [Benjamin Graham, Warren Buffett, and Peter Lynch] do not believe volatility is any measure of investment risk.”
As evidence, he quoted Buffett, who wrote the following in his famous postscript to The Intelligent Investor: “The Washington Post Company in 1973 was selling for $80m in the market. . . . Now, if the stock had declined even further to a price that made the valuation $40m, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland.”
In other words, for Buffett, volatility represents opportunity, not risk.
So, if volatility is not a good measure of risk, what are the investment risks that matter? Wong proposed the following:
- Overpaying for a security or asset
- Investing in the security of a company owned and/or run by dishonest and incompetent people
- Investing in a company that has a weak business model
- Investing in a company with a highly leveraged balance sheet
- Investing in a company that changes its auditor, CFO, and independent directors frequently
- Investing in securities you can never exit
He concluded by reminding attendees that “the problem with statistical measures of risk is that they are based on past performance” and “most risk measures that we use will not work most of the time.”
Against this backdrop, Wong challenged financial professionals to reconsider their beliefs: “Isn’t it time for us to take stock and rethink our concepts about risk?” he asked.
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