Not Your Grandfather’s Risk Measurement
by Deborah Frame, Vice President, Investments, Cougar Global Investments
Why Do We Accept Volatility as a Measure of Risk? — Recognizing the Non-Normality of Asset Class Returns
When you ask an individual what they regard as risk when it comes to their investment exposure, the vast majority answer “losing money”. They have no problem with unexpected high rates of return but they do have a problem with seeing their capital eroded. This is not the same as risk measured as volatility. Some very good articles regarding risk in today’s markets and in portfolio construction have addressed the flaws of looking at volatility as a risk measure. This granular look is premised on the axiom that it is the contributors to volatility, rather than the idea of volatility as a risk measure itself that needs to be understood.
To outright reject volatility as a measure of risk, we need to understand what is being measured, monitored and constraining portfolio asset allocation in institutional investment management today. The work of Harry Markowitz in the late 1950s and early 1960s has left a heavy stamp on this aspect of portfolio management from that time up to this day. The thinking goes like this.Asset classes experience a large distribution of returns over time, typically ranging from losses to returns far in excess of the average return, calculated over the measurement period. Markowitz defined both upside and downside deviation from a mean – mean variance or “volatility” as risk and assumed that losses always exactly equalled gains- the “normal curve”. Until recently, investors have been constrained in their ability to incorporate the true asymmetrical distribution of returns or “non-normality” into the asset allocation process. But now, with the availability of sophisticated statistical tools and modern computing power, we do not need to settle for this simplifying assumption of fifty years ago and can meet the challenge of isolating the probability of suffering losses.
Why is rejecting Markowitz’s volatility and embracing non-normality the key to successful portfolio management?
The most straightforward answer is that this is how the world really works—i.e. we empirically observe non-normality with much greater frequency than the more entrenched mean-variance frameworks allow for. But more importantly, ignoring non-normality in equity (and equity type) return distributions significantly understates downside portfolio risk – losses.
Macro-economic environments result in the incidence of non-normality of asset class return distributions. This, along with the recognition of greater downside risk to asset classes from periodic extreme unexpected negative events and changing economic environments can be incorporated into tactical asset allocation driven portfolio models and delivered with an optimal combination of broad asset class Exchange Traded Funds (ETFs).