In his latest presentation with the ALIGN Spotlight Series, David Herro explains why volatility is not a proxy for risk. Here’s an excerpt from the presentation:
The object is to beat the index, and I would also add I mean there has to be a real rate of return.
Now we didn’t speak of real rates of return for quite some time because inflation was relatively low but with inflation picking up the real rate of return as a concept is very important, so that is to us what investment risk is.
What causes investment risk. Well when you’re looking at companies if you see a business for instance that has too much financial gearing, too much operational gearing, all their sales in one bucket, these things for instance lead to risk because if you’re a heavily financially geared company and business slows down, and if you’re operationally geared you’re in trouble because you’re going to lose money and you have financial debts to pay off.
So to us these are aspects of risk. These are characteristics of risk. A lot of people like to compare volatility to risk and basically the essence is why volatility is not equal to risk.
I would assert that volatility is used to demonstrate risk only because it’s easily measurable. I would say the reason why you don’t use volatility as a proxy for risk is because it only represents risk, remember permanent loss of capital, if you’re a trader, or if you have a very very short-term investment horizon.
If you are an investor and you have a long-term time horizon, and in particular if you have access to cash flows or have access to borrowing, certainly volatility is not risk and we go back to what risk is, losing money, losing the value of your investment.
You can watch the entire presentation here:
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