Source: Maxpixel. CC0.
In physics there’s the principle of conservation of matter and conservation of energy. Matter can’t be created or destroyed. It can only be transformed. In a nuclear reaction, an infinitesimal amount of matter is converted into a tiny amount of energy — only it does it zillions of times, releasing the power of the sun on the earth.
The same law holds with investing. Volatility is part of the market. It’s inherent to the types of securities we hold, and stems from their underlying businesses. Bonds are a senior claim on cash flow. If the company doesn’t pay what it owes, a posse of bondholders will get a court order, enforced by law, to take control of the company’s assets and deliver your claim. That’s what Lehman’s bondholders got after the financial crisis. They ended up with about 40 cents on each dollar of claims.
Stocks are a residual claim on cash flow. There’s no legally enforceable contract, investors just benefit from a voluntary dividend and any growth. Lehman’s shareholders got bunkum when the company went under. Ditto for pets.com and etoys.com after the dot-com bubble.
That’s why bond market volatility is usually a third of stock market volatility. Bond returns are lower, and their variability is lower. What’s more, if you hold a bond until it matures and nothing goes terribly wrong, you know what you’re going to earn. Stocks are more like Forrest Gump’s box of chocolates: you never know what you’re going to get.
Volatility is a proxy for market risk. People don’t like it when stock prices jump all over the place. There are lots of definitions of risk. My personal favorite is the chance of something going wrong. And when the market is jumpy, more things can go wrong.
When you own a US Treasury bond, there are fewer chances of something going wrong than if you have a stake in a limited partnership focusing on early-stage restaurant start-ups. The degree of riskiness is inherent in the investment. When you buy a publicly-traded investment, lower prices mean something has gone wrong – at least for you. Volatility quantifies the jumpiness in prices.
Graph of market volatility. Source: Bloomberg.
With volatility so low lately, investors could be forgiven for asking, “What could go wrong?” But how much risk can we handle? Every investor is different: different needs, different resources, different concerns. We have ways to approximate our risk tolerance, but we don’t really know until we see volatility spike and our investments fall.
Risk can’t be eliminated, just shifted around. The conservation of risk in the markets is like the conservation of matter in the universe. It may not be always visible – the market has “dark volatility” just like the universe has “dark matter.” But eventually, it reappears. Risk is conserved.