by Jack Schwager, via Money & Markets
Volatility is often viewed as being synonymous with risk—a confusion that lies at the heart of the mismeasurement of risk. Volatility is only part of the risk picture—the part that can be easily quantified, which is no doubt why it is commonly used as a proxy for risk. A comprehensive risk assessment, however, must also consider and weigh hidden (or event) risks, especially since these risks may often be far more important.
The confusion between volatility and risk often leads investors to equate low-risk funds with low-volatility funds. The irony is that many low-volatility funds may actually be far riskier than high-volatility funds. The same strategies that are most exposed to event risk (e.g., short volatility, long credit) also tend to be profitable a large majority of the time. As long as an adverse event does not occur, these strategies can roll along with steadily rising NAVs and limited downside moves. They will exhibit low volatility (relative to return) and look like they are low risk. But the fact that an adverse event has not occurred during the track record does not imply that the risk is not there.
Consider, for example, Fund X that employs a strategy of selling out-of-the-money options. Barring abrupt, large moves, the fund will collect premium on options that expire worthless and will be profitable. The track record will be dominated by a large percentage of profitable months and relatively low volatility, providing an appearance of both consistent profitability and low volatility. But does this apparent volatility imply low risk? Not at all. Should the market witness a sudden, large price decline, the risk would explode, as formerly out-of-the-money options move in the money—a transition that is associated with a sharp increase the delta of the options (the percentage by which the option price changes in response to a price change in the underling market). Effectively, then, in this strategy, the greater the adverse price move, the larger the exposure becomes—the very antithesis of a low-risk strategy.
The behavior of investments vulnerable to event risk operates ...
