Portfolio risk and the relevance of volatility
14 November 2014
We allocate money to different asset classes because of the principle that states that different assets perform differently in various markets and in differing economic environments. We don’t have all our eggs in the same basket, so if it drops we don’t lose all.
Is the primary aim to reduce risk or maximise returns?
Coming from a risk-on perspective, asset allocation is first and foremost about reducing risk, from within a particular investment or asset, rather than maximising capital growth. (The 'Brinson et al' study told us about the variability of returns.)
From a risk-off perspective, or cash-from-an-average-investors perspective, deploying money to riskier investments and spreading it around allows for potentially greater returns for adopting a commensurate smaller amount of specific risk.
So how do we measure what amount of risk a particular portfolio is taking?
The first thing to do is to define what risk is. For over 50 years the investment world has used volatility as a standard measure of risk. While it’s not the only risk we take when we invest, it does give us an idea of how variable investment returns have been in the past and therefore volatility can give an indication of how volatile things could be in the future.
Simply put, volatility doesn’t measure the direction of price movements. Rather, it shows the spread of those prices. You can get an idea of risk by looking at the magnitude of spread above and below the average price - a wide spread indicates more risk while a narrow spread means less risk. Statistically, these prices will be within one standard deviation of the mean roughly two thirds of the time.
Using portfolio volatility as our measure of risk is very sensible because we get a numerical output and can then compare portfolios on a scale from low to high risk.