This short paper explores why the investment industry has become so focused on using volatility as a measure of risk, and the potentially dangerous implications that has for long- term investors in achieving their objectives. A long-term investor’s appetite or tolerance for risk should be a direct function of their individual objectives and should not be measured by a short-term metric like volatility. Forecasting returns, not risk, should sit at the heart of long-term investors’ asset allocation strategy.
The increasing focus on forecasting risk, and the emergence of volatility as a popular measure of that risk, is a disappointing response by the investment industry to the recent difficulties it has faced.
Any investment manager would be excused for thinking the last 15 years have been difficult. Since the late 1990s, investors have been faced with an increase in apparent economic and investment uncertainty, especially in comparison to the preceding two decades.
The rising uncertainty stems from several sources, including: significant changes in investment and accounting regulations, not least the transition to marked-to-market pension liabilities under IFRS 13, which crystallises moves in asset prices more frequently on balance sheets; the impact on liabilities of a prolonged period of falling interest rates and therefore discount rates; and, perhaps most critically, the single largest market panic since the 1930s.