Volatility equals risk? Is that really correct?

As investors in the stock markets or businesses with foreign exchange (FX) or other commodities exposure, we need to understand risk.

However, most people have the wrong idea about risk. When we talk about risk, we often assume there is a direct relationship between risk and return, meaning the more risk we take, the higher returns we can expect.

This is a theoretical concept that makes sense if we equate volatility with risk.

There are several reasons why such thinking exists:

Historical Data: When analysing historical data spanning nearly 100 years, it often shows a positive correlation between risk (measured as volatility) and returns. This observation leads some people to assume that higher risk leads to higher returns: looks like all correct - higher risk, higher returns in various asset classes. But this is if we compound average annualised returns geometrically:

Assumptions of Efficient Markets: The belief that markets are efficient and prices reflect all available information leads to the notion that higher risk assets should offer higher returns as compensation for investors. This assumption forms the basis for various investment models and theories.

But if we analyse shorter time periods, such as 5 years, there can be instances where the relationship between volatility and returns may not align with the long-term historical trend. In these shorter periods, there can be periods of high volatility accompanied by low returns, as well as low volatility with high returns. It is not rare then we think about exit for the period of 5 years or less. If we take FX risk, we usually think about few years period maximum, not about 100 years.

Example of 5 years time windows annualised compound returns and volatility: As you can see there are many situations then we have huge volatility and low returns over 5 years period, and low vol and high returns:

If volatility is not risk, then what is risk?

Risk can be defined as the probability of experiencing a permanent loss of capital. It is essential to understand how to assess the likelihood of such a loss.

One way to conceptualise risk is by considering the future as a probability distribution. The outcomes are uncertain, and we cannot predict with certainty which specific outcome will transpire.

The riskier, the higher the uncerntainty and potential of loss:

How to handle?

• Downside focus: It is essential to consider the worst possible scenarios when assessing and managing risk. By identifying and understanding potential downsides, you can take appropriate measures to mitigate or prepare for them. By addressing the potential risks, the upside potential will often take care of itself.
• Understand the risk: Gaining a deep understanding of the risks involved is crucial for effectively managing them. This involves conducting thorough research, analysing relevant data, and seeking expert advice if needed. By comprehending the nature, potential impact, and likelihood of risks, you can make informed decisions and take appropriate actions to avoid or minimise those risks.

By utilizing Corphedge, you can streamline your FX risk management process, enhance decision-making, and increase the overall effectiveness of your risk mitigation efforts. It serves as a valuable tool in managing and minimizing risks associated with your exposure.

Thank you for taking the time to read this article. We hope you found the information valuable and insightful. As members of the LinkedIn community, we appreciate your engagement and contributions!

Prepared: Dainius ?ilkaitis/Corphedge

www.corphedge.com