By: Robert Koloshuk
Chief Investment Officer at WaveFront GAM
Many investors and academics equate risk with volatility. But true risk management goes beyond market swings, it’s about preparing thoughtfully for uncertainty and potential losses. Here’s why we believe that understanding the distinction between risk and volatility matters deeply for our clients’ investments.
Risk vs. Volatility: What’s the Real Difference?
In the 1960s, financial academics began using volatility as their primary measure of investment risk - largely because volatility is simple to quantify. But does volatility truly capture the essence of risk?
Origin of the term 'Volatility'
(The term "volatility" was popularized by economist Harry Markowitz in his foundational work on portfolio theory - Portfolio Selection, 1952.)
At WaveFront, we see volatility as a one of the most predictable and quantifiable properties of financial markets, but not as risk itself. In practical terms, true risk is the probability of permanently losing money. Investors don’t require higher returns merely because a stock might fluctuate in value – they demand compensation for the possibility of actual loss.
Nobody at WaveFront says, “We need higher returns because this investment might fluctuate.” Instead, we position our portfolios to benefit from the fluctuations. Volatility may reflect short-term measures of uncertainty, but it doesn’t represent actual risk. What matters most isn’t how much something moves day to day - it’s whether it can cause permanent impairment.
Ultimately, investors are not rewarded for tolerating noise; they’re compensated for enduring the possibility of real downside, and that is why our focus is on identifying and pricing the true risks, those that threaten long-term value, and not just those that create surface-level turbulence.
Can Risk Really Be Quantified?
Here’s an essential truth as we see it: risk can’t be precisely measured – not before an investment is made, and not reliably afterwards. Identifying risk requires judgment and experience.
Consider this: you invest in something and earn a modest gain of +9% over a year with a 4% annualized standard deviation of daily returns. That sounds measured and probably quite conservative, but what if that return and very low volatility was the result of taking on massive hidden risk? Concentrated factor exposures, excessive leverage, dependence on one type of favorable environment, or severe counterparty risk could have been embedded in that outcome, and despite its low volatility, the Sharpe ratio doesn’t tell the whole story.
Flip it around: you lose -30% on an investment. Was it reckless? Maybe. Or maybe it was a thoughtful decision where a rare, unfavorable outcome materialized. A well-constructed portfolio can still experience a loss, and an extremely risky portfolio can produce consistent, low volatility gains for a decade.
This is the paradox of risk: even with perfect hindsight, the outcome alone doesn’t prove whether the investment was risky or not. A winning, low volatility investment may have been reckless, and a losing, high volatility investment may have been sound.
That's why we see risk not as something you measure once, but something you manage continuously. Great investors aren’t just looking at outcomes, they’re constantly assessing whether the risks they’re taking are justified by the potential reward, and survivable if things go wrong.
In our view, risk is best understood as the range of possible futures, and not the one that actually happened. Managing that uncertainty is the most important skill of successful investors over multiple decades or generations.
The Many Faces of Risk & the Trap of Expected Value
"Risk comes from not knowing what you're doing" Warren Buffett famously remarked. Risk itself isn't inherently bad; it's the lack of understanding that makes it dangerous. Risk isn't limited to potential financial losses. It manifests in numerous forms:
- Opportunity risks: Missing potential gains due to excessive caution.
- Behavioral risk: Letting emotions override process - panic selling, chasing performance, or abandoning strategy mid-cycle.
- Liquidity risk: Being unable to exit a position without significant cost or disruption.
- Capitulation risk: Forced selling at market lows, perhaps the most damaging scenario.
- Tail risk: Rare, devastating events (aka "Black Swans," coined by Nassim Nicholas Taleb in his book The Black Swan, 2007).
Of these, capitulation - selling at market bottoms - is often the greatest threat. Experiencing downturns isn’t as damaging as permanently exiting the market at the worst possible moment.
To navigate this landscape, many investors lean on expected value, the probability-weighted average of potential outcomes as a guide. But this, too, can be deceptive. Consider a simplified example:
- Consider four equally possible outcomes: +20%, +30%, +40%, and -50%. The expected value is +10%, yet +10% isn't a possible outcome and there’s a 1 in 4 chance of -50%. Relying strictly on expected values can lead investors astray, especially when the risk of capitulation lurks.
Wise investors understand that a high expected value isn't enough if it includes scenarios with unacceptable outcomes, like the risk of total ruin or forced selling. Sometimes lower returns with greater ‘safety’ represent a smarter choice. However, there are also many scenarios when higher returns and higher volatility represent a better choice, especially when the risk of capitulation is properly managed.
The Counterintuitive Nature of Risk
Risk doesn’t always behave as intuition suggests. For example:
• In the Dutch city of Drachten, removing traffic signals reduced accidents. Drivers became more cautious precisely because traditional safety measures were removed.1
• Better climbing gear hasn’t reduced climbing fatalities, as adventurers often attempt riskier climbs due to perceived safety improvements—a phenomenon known as "risk compensation."2
These examples illustrate an essential investing lesson: risk isn't just inherent to an investment; it's shaped profoundly by investor behavior. When people perceive safety, they often take greater risks, ironically increasing danger.
Rethinking the Relationship Between Risk & Return
Finance loves buzzwords, simplifications, and cool charts. Nowhere is this clearer than the classic risk-return chart: higher risk supposedly yields higher returns.
At WaveFront, we appreciate true risk. We see distributions of potential outcomes that widen as risk increases, but that isn’t always in direct proportion to what is quantifiable. Long Term Capital Management had very low volatility until they didn’t, and we never permit those types of risks in our portfolios.
Effective risk management isn't just about tracking volatility; it’s about constantly minimizing opportunity risk, behavioural risk, liquidity risk, capitulation risk, and especially tail risk.
Conclusion: The Intelligent Bearing of Risk
True investment mastery arises from managing uncertainty, not avoiding it. Outstanding investors understand risk is unavoidable, unpredictable, and sometimes even hidden under the guise of low volatility. Wise investors prepare by diversifying carefully, pricing risks thoughtfully, and staying disciplined in all market environments.
In summary:
• You can't make returns without bearing risk.
• You shouldn't expect returns simply for bearing risk.
• Expert judgment surpasses quantitative metrics in assessing risk.
• Volatility is a very useful tool for constructing portfolios, but it isn’t real risk.
The best investors have an intuitive grasp of future uncertainties, and they build portfolios that are positioned to capture opportunities while mitigating severe losses.
At WaveFront, our disciplined, thoughtful approach to risk isn't just part of our process - it's fundamental to our philosophy.
Learn more about the WaveFront All-Weather Alternative Fund here
1 In the Dutch city of Drachten, the removal of traffic lights and signs led to a measurable reduction in accidents. This “shared space” urban design approach encourages heightened driver awareness and responsibility. Source: DW News, “Traffic Lights Removed to Improve Road Safety”
2 Despite advances in climbing gear, fatalities have not decreased significantly, largely due to risk compensation—where improved safety equipment leads climbers to attempt more dangerous routes. Source: Outside Online, “The Avalanche Airbag Paradox”
