Long-term investors averse to permanent loss of capital owe volatility an apology

Defining and measuring risk is foundational to investment management. Although there are many legitimate risk measures available, today's discussion will focus on volatility. Why? First, volatility is the easiest to understand and happens to be the “work horse” of applied modern portfolio theory, which is why it's taught in every classroom and continuously discussed on financial market channels such as CNBC and Bloomberg. Secondly, and more importantly, volatility is unfairly under assault by many smart investors focused on the long term and averse to a permanent loss of capital. Over the past few months, I've witnessed disparaging remarks directed toward volatility via the radio, TV, print media and asset manager commentary. In today's piece, I will dissect and reinterpret the typical long-term investor arguments against volatility and explain why volatility is owed an apology.

Let me be clear upfront. Volatility, in general, is an imperfect risk measure. As I've said in previous research, all models are false by definition, including those that use volatility as the sole risk measure. However, these models can still provide valuable portfolio management insights and reasonable rules of thumb to follow. My gripe with the “permanent-loss-of-capital crowd” has nothing to do with highlighting volatility's well-known, generic imperfections. It has to do with their view that these imperfections are magnified as one's investment horizon increases, making volatility less relevant for long-term investors. I completely disagree.

For starters, it's important to define and understand the standard, long-term investor's criticisms of volatility. Here we go:

Volatility is a measure of general price fluctuation. Price movements can either be temporary (i.e., mean reverting) or permanent, and volatility does not distinguish between the two. In the eyes of volatility, all price movements, whether they are temporary or permanent, are created equal and will increase risk.

This is a fundamental flaw from the perspective of a long-term investor. Long-term investors care only about permanent price movements — price drops that aren't expected to recover at all over time and, thus, will lead to a permanent loss of capital. In contrast, temporary price driven volatility is of little concern to long-term investors since these movements are expected to revert. The long-term investor can “ride out” these temporary price drops, making them irrelevant from a long-horizon risk perspective.

At first read, the flaws of volatility do seem to be greater for long-term investors. However, this assumes volatility is being characterized and defined properly. As an ex-Harvard Business School finance professor, I can tell you that the characterization of volatility from the previous section is “typical” but it is incomplete. It's time to hit the books and go back to the classroom.

The investment community discusses volatility as if there were only one unique volatility measure. However, this couldn't be further from the truth. Volatility is investment horizon dependent. There's one-day volatility, one-week volatility, one-month volatility, one-quarter volatility, one-year volatility, 10-year volatility, etc. … I think you get the point. Which volatility measure is relevant for you? It depends on your investment horizon. Volatility should be measured in a manner consistent with your investment horizon. If you are a 10-year investor, you care about 10-year volatility — not, for example, one-day volatility.

What's the fundamental difference between one-day volatility and 10-year volatility? Temporary price movements. Short-term temporary price movements will increase one-day volatility without materially increasing 10-year volatility. Why? By definition, short-term temporary price movements will likely revert back over the longer 10-year horizon, and this will be properly reflected in a 10-year volatility number.

The volatility numbers discussed in the media and among investment professionals tend to be short term in nature — usually somewhere between a one-day horizon and a one-month horizon. Is this bad? Not necessarily. However, it is confusing and sloppy to state these volatility numbers without mentioning the investment horizon information. This critical piece of information is typically left out in practice, giving the impression only “one volatility number” exists.

Should long-term investors averse to permanent loss of capital hate volatility? No. They should hate short-term volatility — not the general concept of volatility. Short-term volatility isn't a relevant risk measure for long-term investors because it's short term — not because volatility, generally speaking, is a poor measure of permanent loss of capital. Long-term volatility will properly distinguish between temporary and permanent price movements, making it a relevant risk measure for long-term investors. Obvious when stated this way, right? For these reasons, I believe volatility has been unfairly thrown under the bus and deserves an apology. Please call and make up. Here's the number: 1-MAR-KOW-ITZZ.

Given the potential theoretical differences in short-term vs. long-term volatility, I think it's helpful to provide context with real volatility numbers estimated from real historical data. In a recent white paper I wrote, I estimated the one-year and 10-year S&P 500 volatility for the 1976 to 2014 time period. Based on my simple model, the one-year and 10-year volatility numbers (per year) were approximately 16% and 13%, respectively. In other words, the role of short-term, temporary price movement (i.e., mean reversion) is material in the historical data, driving a wedge between short-term and long-term volatility. Even a risk framework that solely used volatility would come to the conclusion that long-term equity investors have experienced less risk relative to short-term equity investors. Resorting to new buzz words such as permanent loss of capital is unnecessary.

Volatility is still a relevant risk measure for long-term investors, but make sure to calculate volatility in a manner consistent with your investment horizon, i.e. use short-term volatility for short-term investors and long-term volatility for long-term investors. If you're going to throw someone under the bus, focus on the individual using a short-term risk measure for an investor with a long-term horizon.

Peter Hecht is a managing director at Evanston Capital Management.