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 this distinction 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, we suspect, because volatility was 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 simply as a symptom - an indication of uncertainty - 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 specifically for the possibility of actual loss.
Nobody at WaveFront says, “We need higher returns because this investment might fluctuate.” Instead, we require compensation because there is a genuine risk of losing money. Volatility may reflect uncertainty, but it doesn’t equate to actual risk unless it leads to capital loss. What matters 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. That's why our focus is on identifying and pricing the true risks, those that threaten long-term capital, not just 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 after it, either. It’s inherently subjective—anchored more in judgment and experience than in formulas or backward-looking metrics.
Consider this: you invest in something and earn a modest gain - say 10% over a year. That sounds measured, maybe even conservative. But what if that return was the result of taking on massive hidden risk? Concentrated exposure, leverage, or dependence on one favorable outcome? The result 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 loss, and a poor decision can sometimes produce a gain.
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 investment may have been reckless. A losing one 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, not the one that happened. Managing that uncertainty - not just observing it - is a key component of successful investing over the long term.
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:
- Suppose four equally possible outcomes: 2, 4, 6, and 8. The expected value is 5, yet 5 isn't a possible outcome. Relying strictly on expected values can lead investors astray, especially when catastrophic risks lurk.
Wise investors understand that a high expected value isn't enough if it includes scenarios you simply can't accept, like the risk of total ruin. Sometimes slightly lower returns with greater safety represent a smarter choice.
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.
Consider also asset prices:
• Assets become less risky as prices decline, even though falling prices scare many investors away.
• Assets become riskier as prices climb higher, despite rising prices making investors more confident.
Understanding this paradoxical nature of risk is crucial for successful investing.
High-quality assets aren't inherently safe. Consider the "Nifty Fifty" stocks from the late 1960s: investors lost heavily despite buying America’s 50 "best" companies. Why? They paid unsustainably high prices, turning quality assets into risky investments.
Conversely, assets considered less attractive—like real assets during times of inflation, or undervalued stocks in a diversified portfolio—can offer safety and attractive returns when purchased cheaply enough. Investment success doesn't come from simply buying "good" assets; it arises from buying assets at the right price.
Rethinking the Relationship Between Risk & Return
Finance loves buzzwords, simplifications, and neat charts. Nowhere is this clearer than the classic risk-return chart: higher risk supposedly yields higher returns in a predictable linear fashion. Reality, however, isn't linear.
At WaveFront, we visualize this differently. Rather than a straight line, we see distributions of potential outcomes that widen as risk increases. Higher-risk investments offer potentially higher returns, but also significantly greater uncertainty, including severe losses.
Effective risk management isn't about knowing when to be cautious; it’s about constantly maintaining prudent positioning. Consider auto insurance: you carry it continually, not because you predict an accident, but because you're always prepared.
Think of investing less like American football - clearly divided between offense and defense - and more like soccer, where offense and defense blend seamlessly, continuously, without distinct breaks. Investors must remain consistently positioned for both capturing opportunities and managing 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 often hidden. They 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.
• Subjective expert judgment typically surpasses simplistic quantitative metrics.
Superior investors have an intuitive grasp of future uncertainties. They build portfolios positioned to capture opportunities while mitigating severe losses.
At WaveFront, this 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”
