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Risk and Volatility: Know the Distinction

Risk and Volatility
Risk and Volatility

Risk and volatility are two very different concepts:

Nicola Meaden, a hedge fund researcher, compared monthly standard deviations (volatility as measured from the mean) and semi-standard deviations (volatility measured on the downside only) and found that although trend followers arguably experience higher volatility, it is often concentrated on the upside (positive returns), not the downside (negative returns).

What does this mean? Trend following performance is unfairly penalized by performance measures such as the Sharpe ratio. The Sharpe ratio does not care whether volatility is on the plus or the minus side because it does not account for the difference between the standard deviation and the semi-standard deviation. The actual formula for calculating them is identical, with one exception, the semi-standard deviation looks only at observations below the mean. If the semi-standard deviation is lower than the standard deviation, the historical pull away from the mean has to be on the plus side. If it is higher, the pull away from the mean is on the minus side. Meaden points out the huge difference that puts trend following volatility on the upside if you compare monthly standard (12.51) and semi-standard (5.79) deviation.

Here is another way of thinking about upside volatility: Ponder a market that is going up. You enter at $100 and the market goes to $150. Then the market drops down to $125. Is that necessarily bad? No. Because after going from $100 to $150 and then dropping back to $125, the market might then zoom up to $175. This is upside volatility in action.

Trend followers have greater upside volatility and less downside volatility than traditional equity indices such as the S&P because they exit losing trades quickly with preset stop losses. This means they have many small loses as they constantly try to see if an entry into a market pans out into a big trend.

Michael Rulle, past-president of Graham Capital, helped to mitigate volatility fears:

“A trend follower achieves positive returns by correctly targeting market direction and minimizing the cost of this portfolio. Thus, while trend following is sometimes referred to as being ‘long volatility,’ trend followers technically do not trade volatility, although they often benefit from it.”11 The question, then, is not how to reduce volatility (you can’t control the market after all), but how to manage it through proper position sizing or money management.

Bottom line, you have to get used to riding the bucking bronco. Great trend traders don’t see straight up equity curves in their accounts, so you are in good company when it comes to the up and down nature of making money.

John W. Henry made the clear distinction between volatility and risk:

“…Risk is very different from volatility. A lot of people believe there is no difference, but there’s a huge difference and I can spend an hour on that topic. Suffice it to say that we embrace both volatility and risk and, for us, risk is that we’re going to lose if we risk two tenths of one percent on a particular trade. That is, to us, real risk. Giving back a profit to you probably seems like risk, to us it seems like volatility.”

Henry’s long-term world-view didn’t avoid high volatility. The last thing he wanted to experience was volatility that forced him out of a major trend before he could make big profits. Dinesh Desai, a trend follower from the 1980s, was fond of saying that he loved volatility. Being on the right side of a volatile market was the source of his profits.

Feedback from a listener who gets it:

Greetings Mr. Covel,

During your recent interview with Didier Sornette, you mentioned that you consider risk to be the maximum amount of capital that you can lose. Similar to you, I studied finance in a university and I always disliked the idea that the volatility of an asset’s price is its risk. Perhaps you can produce a podcast discussing the pros and cons of various measures of financial risk. Academia has convinced vast cohorts of students to believe that the historical volatility of an asset’s price is its risk.

Regards,
[Name]

Spot on. How much can you afford to lose? That’s risk.

Risk and Volatility
Risk and Volatility

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