Is Volatility Important?
Volatility is a common feature of a lot of modern theoretical finance.
You see it a lot in modern portfolio theory and metrics like the Sharpe ratio.
It’s also used a lot in practice. Many investment funds target volatility and express their risk as such.
But is volatility important?
That’s what we’ll look at in this article.
When Is Volatility Important?
The short answer is that volatility should be less of a concern for investors:
- whose capital isn’t subject to near-term lump-sum withdrawal
- whose entities are long-lived in nature, such as life insurance companies, pension funds, foundations, and endowments
- whose essential activities won’t be at risk due to downward fluctuations
- who haven’t levered up with debt that has to be repaid in the short run, and
- who don’t have to worry about being forced into certain actions by their constituents
Let’s look at these one by one:
Capital Isn’t Subject to Lump-Sum Withdrawal
If someone is making a decision on whether they have enough money for something – e.g., to make a big purchase, to retire – then volatility is important to consider.
People don’t want to risk running a shortfall because of basic market fluctuations. But in most cases, this isn’t usually a concern.
Entities Are Long-Lived
Life insurance companies, pension funds, foundations, and endowments are all entities with very long lifespans – which typically means they can ride out even the worst volatility spikes over the course of multiple decades.
Even if these organizations suffer losses in one year due to volatility, they’ll still be around come next year.
As such, these organizations generally don’t need to worry too much about short-term volatility when making investment decisions.
Essential Activities Aren’t At Risk
For organizations whose survival is based on the quality of their operations and not the market for the debt and equity, short-term volatility isn’t usually a major concern.
These organizations will remain solvent even if markets swing one way or the other.
Not Leveraged
Leveraging up with debt is a double-edged sword and it especially can create risks when it comes due.
Specifically, leveraged companies and investments are much more sensitive to volatility than unleveraged ones.
In such situations, where repayment is an immediate concern, volatility can be a major issue.
Not Forced Into Mistakes
Finally, if constituents are forcing an organization to make mistakes in order to retain their support – such as investing in assets that aren’t appropriate or taking too much risk to satisfy them – then volatility becomes even more important.
In these cases, the entities need to make sure they don’t take on so much risk that any downward swings could make them insolvent.
Is Volatility the Same Thing As Risk?
No. Volatility is a component of risk in the ways we mentioned, but risk itself is a much broader category.
For example, consider a high-yield bond.
In that case, if you’re simply holding the bond to maturity, your risk is not volatility. It’s the probability of default.
So it’s movement should not matter if you’re not speculating on the bond.
Also consider private assets. They are not marked to market frequently, so they don’t have volatility that you can measure directly.
But that doesn’t mean they don’t have risk.
Private assets can suffer illiquidity risk and operational risk, which often cannot be measured or quantified directly.
Warren Buffett: ‘Volatility does not measure risk’
FAQs – Is Volatility Important?
What is volatility?
Volatility is a measure of the amount and frequency of price changes for an asset.
It can be used to assess how risky an asset may be.
How does volatility affect investments?
The level of volatility affects an investor’s potential return on investment.
If the market is volatile, it increases the risk that investors will experience large losses.
On the other hand, if markets are stable, potential returns and losses may also be lower due to lower levels of risk.
Should I be concerned about volatility?
It depends on your goals and objectives as an investor.
If you need to make withdrawals in the near future or have leveraged investments with debt repayment obligations then volatility should definitely concern you.
Otherwise, long-term investors can generally ride out even the worst volatility spikes over multiple decades.
Additionally, entities with long-term lifespans such as life insurance companies, pension funds, foundations, and endowments generally don’t need to worry too much about short-term volatility when making investment decisions.
Ultimately, it is important to understand the level of risk associated with any investments and make sure that they align with your goals and objectives.
If you are able to manage the risks involved then volatility should be less of a concern.
Conclusion – Is Volatility Important?
Volatility is not always important and it depends on the circumstances of each entity.
For long-term investors with no leverage, constituents demanding unrealistic returns, or essential services not at risk from market fluctuations – volatility won’t be as critical in making investment decisions.
Volatility is a key component of risk in many cases, but it isn’t the same thing as risk, and not all organizations need to worry about volatility if they take the appropriate precautions.
Understanding when volatility matters – and when it doesn’t – is crucial for making sound investment decisions.