Weekend Reading: Why Volatility is the Wrong Measure of Investment Risk

This article appears as part of Casey Weade's Weekend Reading for Retirees series. Every Friday, Casey highlights four hand-picked articles on trending retirement topics and delivers them straight to your email inbox. Get on the list here.
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Weekend Reading

According to the 1950-era modern portfolio theory, volatility is the most appropriate measure for portfolio risk. It draws down to utilizing the statistical concept of standard deviation; but while this makes the metric mathematically simple and easy to estimate, it also carries some disadvantages, which include:


It doesn’t address all the major risks that concern a typical investor: You inherently expect low volatility to produce low returns; however, this can also lead to an insufficient amount of capital to support your long-term income needs. Additionally, a low volatility funded portfolio can have a high-beta exposure to the market if it contains higher exposure to individual stocks. At the same time, assets with historically high volatility can, as stated here, “reduce risk if they are negatively correlated to the portfolio, mitigating the risk that all holdings will decline at the same time.”

It doesn't mean what most people intuitively think it does: When utilizing standard deviation to measure volatility, two investments with the same outcome can appear equally risky. However, the calculation of their mean absolute deviations (or MADs, as shown in the example in this article), can be completely different. As such, measuring the riskiness of an asset based solely on standard deviation doesn’t provide you with crucial information about the nature of its distribution.

It is based on assumptions that don’t fit the real world: To better understand investment risk and how to measure it, becoming well-versed on assumptions versus reality is key - And, you’ll find a handy list included in this article as well that highlights just that. Additionally, your financial advisor should possess a deep understanding of risk analysis that goes beyond the conventional approach to truly create a portfolio that mirrors your personal risk tolerance, based on your values, financial goals and long-term income needs.
Bottom line: Your world continues to evolve. You should ensure the way you are managing risk is evolving along with it.