Too often these days’ market pundits, academics, and other media outlets define risk as volatility. They continue to pound the table stating that the more violently the price of a security wiggles around on a chart the more risky it is. The thought goes that if it can be measured and quantified then it is likely useful and applicable, even to a subject matter as complex as investments. Further, with thousands of statistical studies backing this philosophy and large sums of money invested based on this philosophy it makes sense for investors to take comfort in something so widely accepted.
While volatility can be a sign of risk, it comes so very far from defining risk. Risk is more clearly defined as the probability of a permanent loss of capital, which is the risk that investors are ultimately rewarded for taking. This notion of risk, however, makes investors very uncomfortable because the probability of a permanent loss of capital is impossible to measure with any certainty, even after the fact. For example, if we invest in exploratory oil wells that turn out to be dry and have no oil, does that mean they were a risky investment? If they turn out to hold the next largest reserves on earth, does this mean the investment was less risky when it was initially made? The risk of an investment simply cannot be quantified. If these oil wells were to trade on an open market, we may also face the risk that we overpay relative to true value.
Unfortunately, the path of least resistance continues to push investors to define risk as volatility. However, many intelligent investors continue to take the high road and discuss the probability of a permanent loss of capital as what truly defines risk in the investment world. We understand that because this is an immeasurable figure, volatility must at least be considered, but it is not what should drive the investment decision making process.