This post is a quick response to value-investing folks who might not appreciate why volatility is not just a quant or options concern. It is a response to what I think is a narrow interpretation of Buffet’s dismissal of volatility.
In Buffet: Volatility Is Not A Risk, we find this quote (emphasis mine):
“Volatility is not a measure of risk. And the problem is that the people who have written and taught about volatility do not know how to measure — or, I mean, taught about risk — do not know how to measure risk. And the nice about beta, which is a measure of volatility, is that it’s nice and mathematical and wrong in terms of measuring risk. It’s a measure of volatility, but past volatility does not determine the risk of investing…in stocks, because the prices jiggle around every minute, and because it lets the people who teach finance use the mathematics they’ve learned, they have — in effect, they would explain this a way a little more technically — but they have, in effect, translated volatility into all kinds of — past volatility — in terms of all kinds of measures of risk.”
Volatility is a measure of risk. Is it incomplete? Of course. Literally, nobody thinks it’s the definition of risk with a capital R. No single measure can encapsulate risk or for that matter the merit of any investment.
I’ve discussed these points in various ways before:
I’ve noticed that 10kdiver threads sometimes get push back like “why are you talking about this volatility math, don’t you know Buffet said it doesn’t matter”.
That attitude reflects misunderstanding so in addition to my prior posts, here are a few additional ways to show why volatility matters:
- In one of my favorite all-time papers, My Top 10 Peeves, Cliff Asness places this one as #1: “Volatility” Is for Misguided Geeks; Risk Is Really the Chance of a “Permanent Loss of Capital”.His conclusion is less cranky than his characteristic style:
“I still think this argument is mostly a case of smart people talking in different languages and not disagreeing as much as it sometimes seems.”
The root of the argument is quants are decomposing risk from return and more deferential to mark-to-market, while Buffet refuses to separate risk from return.
- Another one comes from a real vs nominal illusion.It is also conveniently addressed in Asness’s Peeves. Specifically #10: “Bonds Have Prices Too”.
You may hear some people say they want to buy an individual bond rather than a bond fund. They worry that bond fund prices move around and have no real expiration, so when interest rates rise your losses are somehow more real. But if you buy a bond and hold it to maturity you can put your head in the sand, and never lose.
This is nonsense.
You have lost in a real sense since the money you are being returned is worth less in a world in which rates have risen to compensate for inflation. The bond fund is effectively taking your loss today rather than later.
If you sell your bond for a loss, you can reinvest at a higher yield going forward. That’s a similar experience to just being in the bond fund.
Holding to maturity does not mean you have less risk. It’s an illusion.
- This brings me to mark-to-market.Having a preference for private assets that are less volatile simply because their marks are stale is bizarre (although it’s understandable if there is a principal-agent problem at play…hmm, couldn’t possibly be that could it?). They are still volatile. The fundamentals of the private business are correlated with the public market volatility.
Even if you don’t believe your investment should be marked down, then you should be sad you can’t redeem your private investment at par to rebalance into public stocks after the market drops 20%. Giving up liquidity without a premium because it will behaviorally “save you from yourself” sure feels like you sold the option to rebalance at zero.
Further reading: How Much Extra Return Should You Demand For Illiquidity? (7 min read)
- Speaking of options…I’ve seen the argument that holding cash means you don’t have to care about volatility. After all, you can dollar-cost-average into drawdowns.
Um, what?
To say that holding cash means you don’t have to worry about volatility is to misunderstand the arrow of causation. The reason you have cash is because you are concerned about volatility! Cash is liquidity. It’s the ultimate option (its cost is inflation). What maximizes the value of any option including cash?
You guessed it. Volatility.