There ought to be a special word for the “clarification” of a financial expression that threatens to leave people no clearer on the matter than they were before it was supposedly clarified.
One example would be the distinction between financial volatility and risk. Untangling the two concepts and then (partially) reuniting them may be very much what Sherlock Holmes would call “a three-pipe problem”.
Risk is “all downside”
The English language is not exactly an aid to understanding here. In general speech, both volatility and risk tend to be used in negative circumstances – a “volatile” film star, for example, is prone to explode on set in fits of rage, while “risk”, quite simply, is used as a catch-all word for the likelihood of things going wrong.
What is more, even some market professionals use risk and volatility interchangeably. Particularly unhelpful is talk of something called “volatility risk”.
You may well read in market research that the aim of trading or investment is to seek the highest possible return from the lowest level of volatility. This confuses the risk/reward ratio, which is the key to successful activity in financial markets, with a “volatility/reward ratio” that doesn’t really exist – traders and investors seek a reward for the risk that they assume, not for the likelihood that the securities they have bought will move about in price.
So, let’s begin with some very straightforward definitions. A security’s volatility describes the extent to which its price fluctuates, up or down. Its risk usually refers to the likelihood or otherwise that trading this security will result in a loss.
We can see already a key difference here. Because volatility can apply to prices rising every bit as much as them falling, there is a fundamental distinction with risk. The latter is, to put it crudely, “all downside”, while no trader ever fretted about the danger of an asset rising in price – unless, of course, they had gone short.
Volatility need not imply any negative outcome. Indeed, it need not imply any outcome at all. At its core is simply the measurement of a security’s tendency to bounce around in terms of price, usually gauged by plotting the extent to which its price deviates from a benchmark.
For example, a security’s volatility can be measured by the extent to which it behaves in a more or less volatile way than the overall FTSE 100 or Dow Jones. A key measure of this relationship is known as “beta”.
Thus, a stock whose price record shows a 115% movement every time the benchmark has moved by 100% has a 1.15 beta, whereas one that moves only 80% during a 100% shift in the benchmark has a 0.8% beta.
Risk expresses the chance – perhaps in percentage terms – of a negative outcome. This will also give the likelihood of a positive outcome, but this is a by-product of the risk calculation. Risk is harder than volatility to calculate in mathematical terms, and definitions of what constitutes risk are likely to change from one trader to another.
As mentioned earlier, the most common definition is simply that the trade in question will result in loss.
You may be told that risk and volatility operate on different timescales, with the latter being essentially a short-term phenomenon while the latter is best seen over a longer horizon. This is especially the case with equities, which have – until now – tended to appreciate over time, regardless of short-term turbulence.
Danger of a squeeze
But while this consideration has obvious value for an investor, it is of more limited use to traders for whom, in the old market catchphrase, the long term is simply a series of short terms. Furthermore, even the longest-term investing can create losses.
To take two examples, anyone buying General Motors shares on the eve of the 1929 Wall Street Crash would not have recovered their money in inflation-adjusted “real” terms until 1971, while anyone buying UK shares at the height of the bull market that peaked in 1972 would have had to wait until 1986 to get their money back in real terms.
Anyone suggesting to such unfortunate investors that long-term equity-price appreciation is some sort of law of nature would be likely to receive a fairly terse reply.
This takes us neatly to our third stage, where volatility and risk are complementary concepts that – working together – can help traders make better decisions.
To begin with, volatility may not be the same as risk, but it can give rise to risk. The most obvious example of this would be a downward swing in price that would squeeze the trader’s position and force them to sell at a loss. For a short position, the reverse is, obviously, true.
More generally, volatility can signal the presence of growing levels of risk, especially if a rise in volatility marks a break from previous trading patterns and the cause cannot be identified immediately. This sort of sudden fall may signal an unsuspected decline in risk.
No one denies that there is almost certainly some reason behind a sudden increase in volatility. But the point of separating volatility from risk is to make clear that increased volatility does not necessarily mean increased risk.
Considered together, volatility and risk can be powerful analytical tools for traders, especially when employed with a clear idea of how they fit together. But remembering the very important differences between them is essential to an understanding of what they do and, importantly, do not tell us.