Is Volatility A Risk?

A finance version of “categories are made for man”.

What is the definition of “risk”? If you ask a quant, they will say volatility. If you ask Warren Buffet he will tell you that’s stupid and that risk is the chance of permanent loss as opposed to price variation. I don’t want to get into a taxonomy of risk definitions. And I definitely don’t want to get into semantics. Or near-semantics like “risk” versus “uncertainty”.

Just like the border drawn on a map. It has nothing to do with some objective sense of right or wrong. The criteria for evaluating the definition of a border is simply how useful it is. The concept of risk is useful insofar as it helps you judge the merit of an investment. No single measure of risk is sufficient. Think of risk as a multi-faceted prism. The same investment projects different qualities depending on which angle you view it.

Check out this Twitter poll by @Econompic:

This poll targets differing views of risk. It’s trying to find a weakness in the “risk is volatility” definition. It does this by showing that asset B which has very low volatility is an inferior investment. It is, therefore, riskier according to any non-volatility based definition. It is riskier in a common-sense definition of risk. It’s possible however to find a context where the volatility-based definition matters. Let’s say you are a bank and mandated to hold all excess reserves in one of these investments overnight (I know it’s a stretch). Well, the volatility-based definition is useful if losing 2% in one day is an unacceptable outcome.

This exercise a reminder that any definition of risk should be evaluated by its usefulness. Any single definition is incomplete and insufficient for making an investment decision.

Picking on the quants’ definition of “volatility as risk” as popularized by Buffett is not new. Cliff Asness defends the quants in the first item of his cranky list My Top 10 Pet Peeves. (Link)

I also like #10 on poor justifications for individual bonds to bond funds.


I published my notes this week for an old interview between Ted Seides and Basil Qunibi of Novus. Novus is a fund consultant that is best described as “Moneyball for allocators”. Novus does performance attribution. Which means they figure out if a manager’s edge is what they say it is. If a manager’s performance has been due to good timing but they say their edge is security selection you should care. Especially if you attribute timing to luck as opposed to a persistent skill. You will also learn about the 4 Cs that they track and how they predict performance. (Link)

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