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Is Volatility Risk or Reward? A Comprehensive Overview of Strategies to Address Volatility | Recommended by Chongyang

Editor's Note

Volatility is not risk itself; the real risk is 'permanent loss,' but...Volatility is an expression of risk: it triggers investors' fear and behavioral biases...causing risks to materialize and providing counterparties with opportunities to profit.

This gives rise to three perspectives on volatility:

Risk-averse individuals consider volatility as equivalent to risk, something to be avoided.

Risk-seeking individuals view volatility as equivalent to returns, something to be embraced.

Value investors perceive volatility as neutral, with investment risk stemming solely from permanent losses caused by business operational risks.

——BY Thought Steel Imprint

Hereafter, may your reading be fruitful.

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Source/ WeChat Official Account [Thought Steel Imprint]

Author/ Thought Steel Imprint. This article has been authorized for republication; for reprints, please contact the original author.

The views expressed in this article are solely those of the author and represent their independent personal opinions.

It is not the wind moving, but the heart stirring.

Fund A has an annualized return of 15% over the long term, but during market corrections, it often experiences drawdowns exceeding 20%; Fund B has a long-term annualized return of 10%, but during each market correction, its drawdown does not exceed 5%. Which fund do you think is better?

This question is similar to the following diagram, which I have referenced in several of my previous articles: although the returns of several stocks are identical,Ordinary investors find it easier to make money on stocks with smaller fluctuations.

Fluctuation is an issue that is easily overlooked. Most investors focus only on direction, butMany people correctly predict the direction but suffer losses due to fluctuations.

Many individuals treat 'withstanding fluctuations' as a psychological issue separate from investment analysis capabilities — it's not the wind moving, nor the banner moving, but your heart that is moving. However, in academia, fluctuation is not an intangible psychological issue but a tangible risk.

Of course, there are also manyPragmatic investment masters who oppose the view that fluctuation equals risk.Their perspectives are divided into two schools of thought: one regards volatility as neutral, while the other views volatility itself as a source of returns.

Being able to understand the value of a company or asset makes you a good researcher, but only by comprehending the volatility of assets can you become an outstanding investor. This article breaks down the meaning of 'volatility' into several layers.

Academic Perspective: Volatility = Risk

The golden metric for evaluating fund performance, the 'Sharpe Ratio,' suggests that one should not merely look at a fund’s rate of return, but also assess the level of risk it undertook to achieve that return.

But how should risk be evaluated?

From the perspective of traditional financial investment theory, such as Markowitz's Modern Portfolio Theory,Risk is defined as the uncertainty of future returns, manifested in the form of price fluctuations.

Many people do not agree with the notion that 'volatility equals risk.' Volatility is merely a temporary change in stock prices, and investors do not actually incur losses.This is simply a 'mean reversion' illusion created by the term itself. 'Volatility' is viewed from an ex-post perspective.However, at the time when the stock price was plummeting, you had no idea what the future held—whether it would continue to drop or rebound.

At the end of 2013, assuming an investor confidently told you that Kweichow Maotai was facing only temporary difficulties and that its stock price volatility was short-lived, with both earnings and share price bound to recover in the future. This investor would undoubtedly demonstrate great foresight. However, if at this moment they urgently needed cash due to a personal emergency, they would have no choice but to sell at RMB 80 (adjusted price), bearing the losses caused by the fluctuation.

It’s like those holding Maotai shares now—even if the stock eventually replicates the glory seen between 2015 and 2021, as long as you need cash now, you can only sell at the current price.

Although investment is about the future, trading happens in the present. Volatility may be viewed as a process from the perspective of the future, but in the present, it represents an outcome.

Therefore, when calculating risk quantification, the Sharpe ratio usesthe standard deviation of historical return volatilityas a statistical method. The returns of the previously mentioned stocks are identical, but Stock A has higher volatility than Stock B.

If a fund has an annualized return of 15%, a risk-free rate of 3%, and a volatility standard deviation of 12%, then its Sharpe ratio is 1, indicating that for every 1% of risk taken, there is a 1% excess return.

The 52-week volatility of Alibaba is twice that of NetEase. If you want to buy Alibaba, your expected return needs to be double that of NetEase; otherwise, the risk-reward ratio will not be favorable.

Whether you accept it or not, volatility equals risk—the greater the volatility, the higher the risk.The requirement for a higher expected return as compensation represents the actual pricing principle of modern major asset classes., illustrated by two examples:

Example One: The dividend yield of high-dividend stocks is typically higher than the yield of bonds. This holds true even for Yangtze Power, a company with very stable operations, because stock price volatility is much higher than bond price volatility. To achieve the same 'risk-adjusted rate of return,' the dividend yield of Yangtze Power must be higher than the bond yield. The excess portion is called the risk premium, and its quantified form is volatility.

Example Two: As mentioned at the beginning, Fund A has an annualized return of 15% over the long term but often experiences drawdowns exceeding 20% during market corrections. In contrast, Fund B has a long-term annualized return of 10%, but its drawdowns never exceed 5% during market adjustments. If you calculate the average returns of all investors, you will find that the average return of Fund B's investors far exceeds that of Fund A.

Losses caused by volatility are real, and the average return of all historical investors in A-share funds is likely to be negative becausefunds with high returns and high volatility tend to experience 'net subscriptions at peaks and net redemptions at troughs,' whereas funds with low volatility may see net subscriptions at troughs instead.

The difference between the actual returns of investors and the fund’s annualized return also reflects the notion that 'volatility equals risk.' Therefore,unsophisticated retail investors only look at returns, while professional FOFs focus on the Sharpe ratio.

However, regarding the traditional investment view that 'volatility equals risk,' Warren Buffett has explicitly expressed disagreement.

A Practical Perspective: Volatility ≠ Risk

At the 2008 Annual General Meeting, Buffett reiterated his view on equating volatility with risk when responding to shareholder questions:In assessing risk, we believe volatility is meaningless. The most significant risk for us is the risk of permanent loss of capital.

He explained:

You can find all kinds of excellent companies that experience high volatility and generate good profits, but that doesn’t make them bad businesses. Meanwhile, you can also find businesses with very low volatility that are, in fact, terrible investments.

Value investing luminaries such as Howard Marks have criticized the conventional view of equating volatility with risk, arguing that it oversimplifies the real world for the convenience of academic research.

However, Buffett did not say 'volatility is not risk.' What he meant was,Volatility is a neutral concept unrelated to risk.

This makes sense because Buffett only cares about the intrinsic value of a business. For long-term investors like Buffett,Short-term volatility is merely 'noise'—neutral and non-threatening., unless you are forced to sell at the lows.

In fact, Buffett’s understanding of volatility has evolved over time. During his early “cigar butt” phase—where the idea was to buy stocks so undervalued that even a struggling company could generate worthwhile returns with just one more puff—the essence was to profit from downward fluctuations.

Buffett almost always emphasizes in his annual shareholder letters that his strategy is to 'buy low':

In the 1963 letter to shareholders, he stated: Our business is to buy undervalued securities and achieve an average return higher than the Dow Jones Index.

In the 1965 letter to shareholders, he wrote: We look for securities selling at prices below their intrinsic value. The larger the margin of safety, the better we can withstand market volatility.

In reality, The early Buffett did not consider volatility as neutral but rather as an important source of returns.This concept is also the core theory behind multiple investment strategies.

Trading perspective: Volatility = Returns

The perspective that 'volatility = return' must revert to the viewpoint that 'volatility = risk'.

Behind this perspective lies the reality that a large number of investors dislike uncertainty and volatility, especially those managing substantial funds. For instance, do you think sovereign wealth funds or state-owned investment entities would favor volatility? Would social security funds prefer volatility? Would insurance funds embrace volatility?

It is not only these types of risk-averse institutional investors who exhibit such behavior.High-net-worth investors generally display a stronger aversion to return volatility compared to ordinary individuals.The psychology behind this is straightforward: additional wealth does not significantly improve the lifestyle of the wealthy, whereas ordinary individuals often feel they have little to lose (though this is not necessarily true) and believe that even a small increase in wealth can substantially change their lives (which is indeed accurate).

Due to the Pareto principle, 80% of wealth is concentrated in the hands of the top 20% of high-net-worth individuals.Consequently, the actual pricing of assets reflects characteristics of risk aversion, with high-volatility risky assets typically trading at a 'discount'.For example, the previously mentioned dividend yield of stocks being higher than bond yields essentially indicates that stocks are traded at a 'discount' (from the perspective of intrinsic yield similar to bonds).

However, risk itself is an objective reality. If subjective risk pricing exceeds objective facts due to risk aversion, this implies thata portion of the potential returns from risky assets has shifted from risk-averse investors to risk-tolerant ones.

The risk one person wants to avoid is the gain another seeks, just like Littlefinger’s famous line in 'Game of Thrones': 'Chaos is a ladder.'

Thus, 'volatility = return' is essentially the flip side of 'volatility = risk.'

This form of profit transfer is known as volatility trading.

Risk is a 'commodity,' with both buyers and sellers. The most typical example is insurance, where insurance companies earn premiums, while those purchasing insurance transfer a portion of their total asset returns to the insurer in the form of premiums.

Given that volatility equals risk, then'Volatility' can also become a tradable 'commodity,' with options being the most typical example.

The pricing of at-the-money options (where stock price equals strike price) is related to volatility. For two different stocks with the same expiration period and strike price,the higher-priced option is typically due to a higher historical volatility.The buyer of the option (equivalent to the insured party) faces higher odds of payout, making the option more expensive; thus, the seller of the option (equivalent to the insurance company) must charge a higher premium to cover the risk.

Among the Magnificent Seven, Tesla has the highest implied volatility in the pricing of at-the-money options, followed by NVIDIA, then Google and Amazon, with Apple and Meta further behind, and Microsoft the lowest—precisely reflecting their varying levels of historical volatility.

Volatility is not an esoteric concept of 'whether the wind moves, the banner moves, or the heart moves,' but rather represents tangible risks and rewards.

Based on differing attitudes toward volatility, investment strategies can be divided into two types,one being directional trading strategies and the other being volatility trading strategies.

Among traditional equity investors, whether they are value investors or trend followers, although opinions on volatility vary—conservative investors dislike volatility, while value investors consider it an irrelevant factor,direction is always the most important.If the direction is misjudged, losses are inevitable,thus, volatility remains an objectively existing risk.

However, there are also many strategies where returns depend not only on direction but also on volatility.

The strategy most familiar to everyone,is dollar-cost averaging, whose optimal scenario is the emergence of a 'smile curve.'with an initial decline followed by a rise,Part of the return comes from volatility.

More focused on volatility than the dollar-cost averaging strategy is the mean-reversion approach,known as the 'grid trading strategy,' which purely profits from volatility, with directional trends being counterproductive.An upward breakout results in lost positions, while a downward breakout leads to permanent losses. Thus, the most suitable instrument for grid trading is convertible bonds, which have a defined upper and lower limit.

Contrary to grid trading is the strategy focused on breakouts,known as 'trend trading,' where both direction and volatility are equally crucial.The essence of a 'breakout' lies involatility constrained within a price range, which suddenly amplifies when the price breaks out of the range.In commodity futures trading, where both long and short positions are possible, one must correctly predict the direction and the speed of the breakout. If both are accurately assessed, it's like a celebration; if one is wrong, there will be losses, and if both are incorrect, it could result in significant financial distress.

Trend trading is exciting, but in the eyes of a pure options trader, guessing the direction is meaningless gambling. What they want isreturns from volatility, which can be achieved by constructing an options portfolio to hedge out both long and short directional exposures, or even eliminate sensitivity (Delta), leaving only the pure impact of volatility.

Although both involve trading volatility, the risks and rewards vary: grid trading prefers moderate fixed volatility levels—neither too high nor too low. In contrast, options volatility trading strategies have distinct approaches for rising or falling volatility, with the greatest fear being unchanged volatility or misjudging its direction.

Volatility is the essence of the financial world.

Let us first review the main points of this article:

Volatility is not risk itself; the real risk is 'permanent loss.' However,volatility is the manifestation of risk: it triggers investors' fears and behavioral biases,turning risk into reality while also providing profit opportunities for counterparties.

From this, three perspectives on volatility emerge:

Risk-averse individuals believe that volatility equals risk and is something to be avoided.

Risk-seeking individuals believe that volatility equals returns and is something to be embraced.

Value investors view volatility as neutral, believing that investment risk arises solely from the permanent losses caused by business operational risks.

All three attitudes correspond to strategies that can generate profits, with thecore lying in understanding what is predictable and what is not:

Institutional investors, through diversified asset portfolios and robust research capabilities, believe that returns are controllable, but investor sentiment is not. Thus, they choose to manage volatility.

Investors aiming for high returns believe they can manage their mindset in the face of continuous failures and substantial drawdowns. They are willing to bet on both direction and volatility to achieve higher returns and therefore embrace volatility more actively.

Value investors believe that market volatility is uncontrollable, but the ability to assess corporate value can be improved. They adopt a neutral and detached attitude toward short-term stock price fluctuations.

Regarding volatility itself, it is also important to differentiate between what can be assessed and what cannot:

Some investors believe that predicting the magnitude of volatility is more challenging, while judging its direction is relatively easier, such as with the pendulum theory. This has led to various timing strategies based on mean reversion and trend trading.

Some investors believe that while the direction of volatility is difficult to predict, changes in volatility follow discernible patterns. Therefore, they favor designing direction-neutral volatility trading strategies.

When it comes to how to utilize volatility, it is also important to distinguish between what can be predicted and what cannot.

Some investors argue that humans exhibit certain inherent response patterns when facing volatility, many of which constitute behavioral biases. Consequently, numerous strategies targeting such biases have emerged, colloquially referred to as 'harvesting韭菜'.

Other investors contend that these behavioral biases not only create numerous trading opportunities but also lead to biases in their own decision-making. As a result, they have developed many quantitative strategies executed automatically by machines, some even incorporating automated learning capabilities.

Therefore, volatility is not an anomaly,but rather an intrinsic characteristic of the financial world. It serves as a reminder that the world is constantly changing, compelling us to differentiate between what we can control and what we cannot,as well as what we can predict and what remains unpredictable.

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