Risk vs Volatility

Most of us think that volatility is same as risk. Given a choice we prefer to work for the government or some big corporations. We prefer holding cash and fixed instruments instead of equities. Why? These options are less volatile and hence we consider them as less risky. This assumption is incorrect. Volatility is not the same as risk. Things that are volatile can also be less risky. Let us learn about risk and volatility from Buffett and Taleb.

Buffett on Risk and Volatility

In 1993 Berkshire Hathaway’s shareholders meeting one shareholder asked the following question

Wall Street often evaluates the riskiness of a particular security by the volatility of its quarterly or annual results and likewise, measures money managers’ riskiness by their volatility. I know you guys don’t agree with that approach. Could you give us some detail about how you measure risk?

Buffett responds

We regard volatility as a measure of risk to by nuts. And the reason its used is because the people that are teaching want to talk about risk and the truth is that they don’t know how to measure it in business. Part of our course on how to value a business would also be on how risky the business is. And we think about that in terms of every business we buy. Risk with us relates to several possibilities. One is the risk of permanent capital loss. And the other risk is that there’s just an inadequate return on the kind of capital we put in. However, it doesn’t relate to volatility at all. For example, our See’s Candy business will lose money and it depends on when Easter falls in two quarters each year. So it has this huge volatility of earnings within the year. Yet it’s one of the least risky businesses I know. You can find all kinds of wonderful businesses that have great volatility in results. But that doesn’t make them bad businesses. Similarly, you can find some terrible businesses with very low volatility. For example, take a business that did nothing. It’s results wouldn’t vary from quarter to quarter. So it just doesn’t make any sense to equate volatility with risk.

In 2011 letters to shareholders he writes

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”

Taleb on Risk and Volatility

I recently finished reading the book The Black Swan by Nassim Taleb. It’s a terrific read and I learnt a lot about how black swan events explain almost everything about our world. He writes

People are often ashamed of losses, so they engage in strategies that produce very little volatility but contain the risk of a large loss – like collecting nickels in front of steamrollers. In Japanese culture, which is ill-adapted to randomness and badly equipped to understand that bad performance can come from bad luck, losses can severely tarnish someone’s reputation. People hate volatility, thus engage in strategies exposed to blowups, leading to occasional suicides after a big loss.

Furthermore, this trade-off between volatility and risk can show up in careers that give the appearance of being stable, like jobs at IBM until the 1990s. When laid off, the employee faces a total void: he is no longer fit for anything else. The same holds for those in protected industries. On the other hand, consultants can have volatile earnings as their clients’ earnings go up and down, but face a lower risk of starvation, since their skills match demand – fluctuates but doesn’t sink… I learned about this problem from the finance industry, in which we see “conservative” bankers sitting on a pile of dynamite but fooling themselves because their operations seem dull and lacking in volatility.

Risk and volatility are not the same. Some of the biggest payoffs have come from volatile ventures.

In an ever changing world nonvolatile jobs gets outsourced or made obsolete by technology. Governments and big corporations have gone bankrupt and are forced to eliminate jobs. We need to keep learning and fear about non-volatility.