volatility as risk

I was listening to Bloomberg radio the other day when a talking head who usually has interesting things to say (an increasing rarity on Bloomberg) began to “explain” how 2015 was a very risky year for stocks.  This, even though the S&P 500 was ending December in basically in the same place it started out in January.

Measures of interday change in individual stock prices were also relatively benign   …but, he said, intraday price movements in stocks were unusually high.  Therefore, stocks were riskier than usual.

Yes, in a very tortured sense…or for a day trader who’s consumed by hour-to-hour price movements…that might be so.  For you and me, though, that’s crazy.

Last September 14th I wrote another post about the academic notion that investment risk can be defined as day-to-day volatility, i.e., the daily change in the price of a given security.

The main pluses for this idea are that it’s simple, the data are readily available and you don’t have to know anything about the security in question or the goals of the holder.

In my earlier post, I pointed out that this notion led to catastrophic results in the late 1980s-early 1990s for institutional holders of commercial real estate and junk bonds.  Neither traded very often, so the daily price–as determined by the last actual transaction–rarely changed. Volatility was negligible.  What a surprise when lots of people wanted to sell at the some time, only to find that low volatility didn’t represent safety.  It signaled illiquidity–there were no buyers at anywhere near the last trade.

not a 100% useless concept

There is a sense in which volatility may be important, though.  Over several year periods, stocks tend to follow an up and down pattern that mirrors the business cycle, with stocks leading the economy by about six months.  Over longer periods, stocks tend to advance on trend around the rate of growth in reported profits, which has historically been about +8% per year in the US.

If you’re in your thirties or forties and saving for your retirement or to pay for your young children’s college tuition, then daily or even business cycle fluctuations in stock prices are irrelevant now.  Investing in stocks that have low volatility–which usually also comes with low appreciation potential–makes no sense at all, despite the notion’s academic pedigree.

On the other hand, if you’re saving, say, for a wedding or to buy a house and will need the funds in six months or a year, then having it in stocks is probably a bad idea.  That’s because prices could easily be 10% below today’s level when you need the money.  Just look at a chart of the S&P 500 in 2015–which chronicles a mid-summer S&P swoon– to see what I mean.  In this case, keeping your money in (low-volatility) cash is the better course of action.