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02 November 2017 Volatility - A Risky Measure?

There are many kinds of risks...but volatility may be the least relevant of them - Howard Marks, Co-Chairman Oaktree Capital Management

Investors are familiar with the disclaimer “past performance is not a reliable indicator of future returns” but perhaps “past volatility is not a reliable indicator of future capital loss” should be added to the standard warnings provided to private clients? With the headline volatility of equities near record lows and seemingly not reflecting the perception of investors following recent market events, the question of whether current volatility statistics are misleading investors warrants investigation.

Volatility Is Absolutely Useless ….

In common parlance, the word volatility conveys a tendency to change quickly and unpredictably, often for the worse. For example, a person may be said to have a volatile temper. However, in the world of finance the meaning of volatility subtly changes from being something that is unpredictable to being something that can be measured. Thus the volatility of an investment is not a comment on the unpredictability of the returns from an investment but a statistic suggesting a predictable range of outcomes! And the most widely used volatility statistics are based on the variability of historical returns.

Most investors understand that the variability of historical returns is an inadequate expression of the current and future risk of holding an investment.  However, despite being a poor indicator of risk, the historical pattern of returns is an objective, empirical test that is widely used to analyse the “risk” of investments. In the Q2 2015 PCI Commentary it was noted that the absolute volatility of world equities is not a constant. Indeed the three year rolling annualised “volatility” of returns for world equities has ranged between 10% and 20% over the last fifty years or so. Using current volatility as a measure of potential future loss is a fool’s paradise.


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