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.