Many investors assume that risk and volatility are really the same thing. There is, however, a very important distinction and one that should not be overlooked.
Jack Schwager is renowned for his Market Wizard books, and his newest addition, Hedge Fund Market Wizards contains a number of interesting conversations around this idea of risk versus volatility. The Market Wizard books are must reads for traders or wanna-be traders. Each of the series sits on my top bookshelf and I return to them on a regular basis. (An interview with Schwager about the book can be found here:http://www.opalesque.tv/hedge-fund-videos/jack-schwager/1)
Many people equate volatility with risk. But Schwager is quick to point out that such an idea is not only false, but dangerous. When choosing a strategy or a fund to invest in, people are drawn to smooth upward sloping profit and loss graphs. But those graphs often betray the real risks.
“There are many strategies that make moderate amounts of money most of the time, giving low volatility track records. Once in a while, these strategies are prone to huge losses- they are highly left-skewed. They make money most of the time, but once in a while can lose a lot. These are strategies which are explicitly or implicitly short volatility.”
In his famous book, The Black Swan, Nassim Taleb uses the example of the Thanksgiving Turkey to show low volatility and high (unknown) risk. The turkey’s life is one of good food and care right up until that last day.
The least volatile investment one could have made in 2007 was in Bernie Madoff’s fund, and we know how that ended – just like the turkey. But there are many funds and strategies that are not frauds but still mask their risk in low volatility. As Schwager mentions, strategies that are explicitly or implicitly short volatility do just that.
Many option traders are drawn into option selling strategies for just this reason. They produce steady, solid returns most of the time. The P/L is a nice upward sloping track. I know of one options newsletter/auto-trade service that provides amazing steady returns – and then blows up about every four years. That may be ok for hedge funds you don’t own. But that doesn’t work for individual investors or traders… or turkeys.
I honestly don’t have a problem with short volatility strategies, and I use some myself. But don’t be fooled by low volatility, especially when looking at returns that don’t include big downturns in the respective markets (supposedly Long Term Capital Management didn’t include 1987 in the risk models on their strategies when they blew up about 10 years later). Using protection and limited risk selling strategies is the appropriate way to approach such strategies, even if the returns aren’t quite so impressive. Don’t be fooled into thinking that low volatility is low risk. Don’t be a turkey.