Financial markets often disregard the fundamental difference between volatility (the magnitude of price fluctuations) and risk (the probability and scope of permanent losses). Standard risk management and academic models rely upon volatility alone. Alas, this reliance can induce an illusion of predictability and excessive risk taking. Indeed, low volatility can indicate and even aggravate the risk of outsized permanent losses.

Marks, Howard, “Risk  Revisited Again”, Oaktree Capital Management, Memo to Clients, June 9, 2015

The below are excerpts from the memo. Headings and cursive text have been added.

Defining risk and volatility

“I [have long] argued against the purported identity between volatility and risk. Volatility is the academic’s choice for defining and measuring risk [through historic standard deviations of daily price changes]. I think this is the case largely because volatility is quantifiable and thus usable in the calculations and models of modern finance theory.”

“In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing…What they fear is the possibility of permanent loss…Permanent loss is very different from volatility or fluctuation. A downward fluctuation – which by definition is temporary – doesn’t present a big problem if the investor is able to hold on and come out the other side.”

On the contradiction between volatility-based regulatory risk measures and true loss and underperformance risk in the EU insurance industry view post here.

“If you define risk as anything other than volatility, it can’t be measured even after the fact….If you make an investment in 2012, you’ll know in 2014 whether you lost money (and how much), but you won’t know whether it was a risky investment – that is, what the probability of loss was at the time you made it.”

The essence of investment risk

Riskier investments are ones where the investor is less secure regarding the eventual outcome and faces the possibility of faring worse than those who stick to safer investments, and even of losing money.”

“[In the graph below] the result of each investment is shown as a range of possibilities, not the single outcome suggested by the [conventional risk-return] upward-sloping line. At each point along the horizontal risk axis, an investment’s prospective return is shown as a bell-shaped probability distribution turned on its side….As you move to the right, increasing the risk [i] expected return increases, [ii] the range of possible outcomes becomes wider, and [iii] he less-good outcomes become worse.”


Investments that seem riskier have to appear likely to deliver higher returns, or else people won’t make them…If the market is rational, the price of a seemingly risky asset will be set low enough that the reward for holding it appears adequate to compensate for the risk present. But note the word ‘appear’. We’re talking about investors’ opinions regarding future return, not facts. Risky investments are – by definition – far from certain to deliver on their promise of high returns. “

“There are actually two possible causes of inadequate returns: (a) targeting a high return and being thwarted by negative events and (b) targeting a low return and achieving it. In other words, investors face not one but two major risks: the risk of losing money and the risk of missing opportunities. Either can be eliminated but not both… When credit risk, illiquidity risk, concentration risk and leverage risk are borne intelligently, it is in the hope that the investor’s skill will be sufficient to produce success. If so, the potential incremental returns that appear to be offered as risk compensation will turn into realized incremental returns.”

Risk estimation has to be the province of experienced experts, and their work product will by necessity be subjective, imprecise, and more qualitative than quantitative…Only investors with unusual insight can regularly divine the probability distribution that governs future events and sense when the potential returns compensate for the risks that lurk in the distribution’s negative left-hand tail. In other words, in order to achieve superior results, an investor must be able – with some regularity – to find asymmetries: instances when the upside potential exceeds the downside risk.”

The dangers of relying on quantitative risk measures

“The key hazard of quantitative risk management is the illusion of control the models and their results impart to us…Even…a so-called statistically significant outcome, which is 95% certain…still leaves 5% you know nothing about… I have no interest in being a skydiver who’s successful 95% of the time.”

“People usually expect the future to be like the past and underestimate the potential for change…History that took place is only one version of what it could have been. If you accept this, then the relevance of history to the future is much more limited than many believe to be the case… history tells us over and over again that the unexpected and the unthinkable are the norm, not an anomaly.”

“Not only can extreme events exceed a model’s assumptions, but excessive belief in a model’s efficacy can induce people to take risks they would never take on the basis of qualitative judgment…’Value at Risk’ was supposed to tell the banks how much they could lose on a very bad day. During the [2007-08] crisis, however, VaR was often shown to have understated the risk, since the assumptions hadn’t been harsh enough…more money was spent on risk management in the early 2000s than in the rest of history combined…and yet we experienced the worst financial crisis in 80 years.”

On how statistical risk models increase financial crisis risk also view post here.

“While expected value represents the probability-weighted average of all possible outcomes…just one of the many things that can happen will happen…And if some of the paths under consideration include individual outcomes that are absolutely unacceptable, we might not be able to choose on the basis of the highest expected value. We may have to shun the quantitatively optimal path in order to avoid the possibility of an extreme negative outcome.”

“While I don’t think volatility and risk are synonymous, there’s no doubt that volatility does present risk. If circumstances cause you to sell a volatile investment at the wrong time, you might turn a downward fluctuation into a permanent loss. Moreover, even in the absence of a need for liquidity, volatility can prey on investors’ emotions, reducing the probability they’ll do the right thing.”

When low volatility indicates high risk

“Can we sustain the low-risk character of the environment when it leads many investors to take high risks and to overvalue risky assets in search for higher returns?…The more risk we take because we believe the environment is low-risk in character, the less the environment continues to be low-risk in character…Greater liquidity…leads firms to borrow more than before. But higher levels of debt mean increasing vulnerability to adversity and negative shocks in an ever-changing world. For these reasons, as [Hyman] Minsky put it, stability leads inevitably to instability.”

“Simply put, risk is low when risk aversion and risk consciousness are high, and high when they’re low…Fear that the market is risky (and the prudent investor behavior that results) can render it quite safe. As an asset declines in price, making people view it as riskier, it becomes less risky (all else being equal). A low price provides a ‘margin of safety’ and that’s what risk-controlled investing is all about.”