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, Random Roger (173 clicks)
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Cliff Asness' list of pet peeves is making its way around the financial interwebs. Here is a shorter version from Market Watch and a longer version from Financial Analysts Journal. There's a lot to digest but this post will just focus on peeve number 1, which has to do with the extent to which people interchange risk and volatility and have the wrong framework in his opinion for understanding risk.

Asness says people need to think about volatility as volatility relative to expected return, such that volatility becomes the amount you can be wrong by either good or bad. That's interesting, but not much use to too many people.

A more practical application is to think about expected volatility versus a broad benchmark index. A diversified portfolio that goes narrower than just broad index funds will have some holdings that are more volatile than the broad market and some that are less and they will all combine to make a portfolio that overall is more or less volatile than the broad market. Ideally, the combo resulting in more or less volatility is what the investor is targeting.

More volatile ETFs could include home builders, auto manufacturers and funds that have terms like high beta in the name. Less volatile funds could include staples, utilities and funds that have terms like low beta in the name.

There is no guarantee that the iShares Home Builder ETF (NYSEARCA:ITB) will always be more volatile than the S&P 500 but the vast majority of the time it will be. ITB may or may not be a good investment or trade (not the point of this post) but it is important for anyone taking a position to understand it will likely be more volatile than the market -- the iShares site reports ITB's beta at 1.72.

In terms of risk and volatility not being the same thing, Asness refers to the term permanent impairment of capital. During the worst of the financial crisis, I made the point repeatedly that the S&P 500 would absolutely come back and make a new high but that the variable was when it would occur. This may seem obvious now but I was met with plenty of resistance on this point back then.

For someone not needing the money in the mean time, the 56% decline in the SPX and subsequent bounce back were more about volatility than risk. Reasonably speaking, the S&P 500 or any other large index will not fail. The next time it cuts in half maybe it will take ten years to come back, but it will come back. The same cannot be said for individual stocks. Although it has always been true that any stock can fail, the point was really driven home during the financial crisis.

Obviously the context here is investment risk. An unluckily timed retirement around the financial crisis or some sort of emergency requiring a meaningful withdrawal after the market fell are not investment risks, they are more along the lines of financial plan risk.

Disclosure: No positions

Source: Cliff Asness' 10 Peeves