There’s much talk of market volatility these days. But – from the point of view of the long term investor – how much does volatility matter? Doesn’t it all just wash out? Volatility does matter, but it’s important to be clear on the distinction between two different manifestations of volatility: two flavors that are not the same thing at all, but that frequently get mixed up.
How bumpy is the ride? How certain the destination?
One type of volatility – what we might call time series volatility – is the version that is probably the most familiar: it’s a measure of how variable a given series of returns is through time along a single path of experience. The second type of volatility is a measure of the width of the range of possible outcomes at the end of some specified time period. So one measures the smoothness of the ride, the other the variability in the destination.
These are obviously related to some extent. Indeed, in some naïve models of investment behavior, the two versions are equivalent to one another: most notably, if you assume that there’s no trending or mean reversion in your return patterns, then they become very closely related. The problems begin if the two types of volatility are used interchangeably.
Consider these two investment strategies:
- Buy and hold a ten year bond for ten years. The value of this investment will fluctuate over the ten years as interest rates vary. But the ending value (the distribution of outcomes) is not very uncertain at all (the only source of uncertainty being that attached to reinvestment of the coupons received.) So here, using time series volatility would paint a riskier picture than focusing on the distribution of outcomes.
- Invest in cash. Here, the variation in returns from month to month will be pretty small. But over a longer time period, the uncertainty magnifies. The range of returns that cash may deliver in the next twelve months is not large, but with each year we move out into the future, the range of possible outcomes expands. So in this example, the distribution of outcomes paints a riskier picture than the time series volatility.
This is why Russell Investments’ capital market assumptions – available with client login – show both measures of volatility. (And the latest edition shows, for example, that the expected time series volatility of cash is less than one third the size of the volatility as measured by distribution of outcomes at a twenty year horizon, while the time series volatility of long-duration bonds is more than twice as large as the distributional volatility.)
Both versions of volatility matter to institutional investors. Of the two, it is generally the uncertainty of the possible outcomes that is more important, but the bumpiness of the ride matters, too. (Click here for why the journey, as well as the destination, matters.) But it’s important to keep in mind that they are not the same thing.
If you want more on the distinction between a single-path focus and a distributional focus – and you enjoy having your brain twisted – click here for an introduction to the volatility paradox.