STREET DOGS

From an article by Eric Lonergan at Philosophy of Money:

When asked what the biggest bubble is out there, I point to “volatility”. Not low or high volatility. But the very concept.

Volatility-based frameworks are omnipresent. Portfolio risk is measured using value-at-risk models that attempt to capture the volatility of a portfolio, and specify probable losses with varying degrees of statistical confidence. Investors everywhere are being encouraged to define their “risk profile”. This translates into constructing portfolios which target levels of volatility – the risk-averse are encouraged to invest in less volatile funds, the risk-takers are to move higher up the volatility spectrum.

Every corner of the investment industry is obsessed with volatility.

The first of three significant problems with this intellectual virus is typically unrecognised: investor behaviour is becoming correlated. That’s jargon for saying more people are behaving in exactly the same way … one of the most compelling explanations as to why asset prices move by far more than is warranted by changes in underlying fundamental news.

Technology has played an important role as carrier of this virus. Technology creates an incentive to quantify. That is the fundamental appeal of a statistical, price-based measure of risk….

But, volatility is not risk. Measuring volatility using daily prices and three-month trailing sample periods should be no one’s measure of risk, other than a leveraged Vix trader. Most investors should be thinking at least in terms of five-year horizons. Some phenomena have measurable probabilities, some don’t. The semantics of “risk” suggests far richer concerns than merely measuring the standard deviations of security prices.