The biggest lie in investing is that volatiliy = risk.

This is bogus. It misses the point of risk. Risk is about the chance of losing your principal in an investment. Volatility does not capture that whatsoever. What does it matter if the price of an investment swings wildly up and down, so long as the mean of those swings always trends upwards?

Example

The graph below is a highly volatile investment but the trend of the volatility is always upwards. If we’ve done our own risk assessment then this sort of upwards volatility doesn’t matter to us.

Volatile but low risk
Volatile but low risk

An oft repeated mantra in investing is that “past performance doesn’t guarantee future performance.” If we know this then why do we think that past volatility can somehow predict future risk? One theory is that academics are searching for a way to quantify risk. Another is that figuring out when to buy and sell a volatile investment looks difficult and risky.

When do you buy, when do you sell?

If a stock is extremely volatile, when do you buy in and when do you sell? You wouldn’t want to end up buying at a peak and killing your returns if you sell in a dip.

Red - buys peak, sells future dip. Blue - buys dip, sells future peak
Red - buys peak, sells future dip. Blue - buys dip, sells future peak

In the above example, blue makes a killer return and red makes a shitty return even though they both hold the investment for nearly the same period of time. This problem of buying and selling volatile investments is why many investors end up equating volatility with risk. We can easily compensate for price swings through two techniques, however.

  1. The time horizon for holding an investment should always be long term. If you don’t believe in the investment enough to hold it for more than 5 years, you shouldn’t buy it.
  2. Dollar cost averaging.

Dollar cost averaging is the technique of spreading your total investment out over time. Rather than put $200k down all in one day on a volatile investment, put $20k down every month for the next 10 months regardless of asset price. This type of buying at a fixed interval moves your average price paid closer to the mean (dotted black line in the graph). Taking the same approach when selling will give you a return close to the mean.

Dollar cost average is a very passive way of buying and selling. Something I’d recommend when buying into index funds or established companies. If you’re buying into emerging companies you should be doing your own price & risk assessments which will further inform when you should buy and sell.

Assessing Risk

So how do you assess the risk of an investment? Stay tuned for the next post.