The Active Equity Renaissance: New Frontiers of Risk

Categories: Behavioral Finance, Drivers of Value, Economics, Equity Investments, History & Geopolitics, Performance Measurement & Evaluation, Portfolio Management, Risk Management

The Active Equity Renaissance: New Frontiers of Risk

Co-authored by C. Thomas Howard

One modern portfolio theory (MPT) pillar that is unquestionably broken is the use of volatility, specifically standard deviation, as a measure of risk. This initial error in MPT’s development is a major contributor to active investment management underperformance.

Volatility Is Not Risk

The concept of volatility as risk rests on a critical assumption that is overlooked by most of the industry: Only in finance is risk defined as volatility, or the bumpiness of the ride.

Various dictionary definitions of risk converge on something like the “chance of loss.”

  1. Noun: exposure to the chance of injury or loss; a hazard or dangerous chance.
  2. Insurance: the degree of probability of such loss.
  3. Verb: to expose to the chance of injury or loss; hazard.

Not a single definition includes volatility as a part of its explanation. Dictionary definitions and popular understandings of risk might differ from a business definition, yet a popular business dictionary describes over a dozen different forms of risk, ranging from exchange rate risk to unsystematic risk, all of which focus on the chance of permanent loss.

The insurance business relies on an understanding of risk, and an insurance licensing tutorial says that “Risk means the same thing in insurance that it does in everyday language. Risk is the chance or uncertainty of loss.”

Only finance defines risk as short-term volatility. Why? In the 1950s, academics recognized that hundreds of years of statistics research thinking could be borrowed to analyze the performance of investment portfolios — if some of the definitions could be bent to their aims. Once standard deviation was transformed into “risk,” the work of analyzing portfolios could begin and theories could be developed.

The Origins of This Misconception

Harry Markowitz states, “V (variance) is the average squared deviation of Y from its expected value. V is a commonly used measure of dispersion,” in his seminal 1952 Journal of Finance paper “Portfolio Selection.” Then he continues:

“We next consider the rule that the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing. . . . We illustrate geometrically relations between beliefs and choice of portfolio according to the ‘expected returns — variance of returns’ rule.”

Whoa, hold on a second! Investors do want variance of return, and to the upside. Not only that, how did a blithe proposition regarding a statistical calculation turn into a rule in less than a paragraph? As Markowitz then states, again blithely, “[This rule] assumes that there is a portfolio which gives both maximum expected return and minimum variance, and it commends this portfolio to the investor.”

This sentence creates a major problem for how investment managers are currently evaluated. When investment product distributors prefer “maximum return versus minimum variance,” then closet indexing is not far behind.

Markowitz is borrowing on hundreds of years of statistical theory to make an important point: Diversification can lead to better outcomes in investing. But to make the leap to volatility and its close cousin, beta, as risk measures, as much of the industry has done, is an egregious mistake.

Volatility Is Emotions

Nobel laureate Robert Shiller showed that stock prices fluctuate much more than the underlying dividends, the source of value, in his seminal paper. The implication is that stock price changes are largely driven by something other than changing fundamentals. Volatility is the result of investors’ collective emotional decisions. Shiller’s contention has withstood the test of time. Numerous studies have attempted and failed to dislodge it.

So not only does volatility capture both undesirable down price movements along with desirable up movements, it is mostly driven by the collective emotions of investors and has little to do with fundamental risks. Since emotions are transitory and much of the resulting effect can be diversified away over time, volatility fails as a risk measure.

Finally, some maintain that since investors enter and exit funds based on strong short-term upsurges and short-term drawdowns, volatility represents business risk for the fund. But why should fund business risk be intertwined with investment risk? There need to be separate measures since the risk faced by investors and funds is distinctly different.

Possible Risk Measures

So if volatility as risk is flawed, how do we measure investment risk? The metric should focus on the chance of permanent loss — investment value dropping to zero, for example — or the opportunity cost of underperforming a benchmark.

Qualitative Risk Measures

One approach that we used at the Davis Appreciation and Income Fund is to carefully consider the fundamental risks facing a business. The varieties of risk could include economic, environmental, political, regulatory, public opinion, geographic, technology, competition, management, organizational, overhead, pricing power, equipment, raw materials, product distribution, access to capital, and capital structure, to name a few.

If the business is affected by one or more of these risks, that will likely influence the firm’s ability to make good on its promises regardless of where you claim a cash flow in its capital structure (debt, preferred, convertible, equity, option, etc.). One drawback of such evaluation techniques: The subjective nature of these risks cannot be summarized in a single measure. But the truth is investment risk is complex and multifaceted, so no single number could suffice, much less an emotionally driven statistical measure like standard deviation.

Returns Relative to Opportunity Set

Pioneering work by Ron Surz called Portfolio Opportunity Distributions (POD) takes an entirely different approach. This performance- and risk-evaluation technique examines the strategy laid out by the investment manager in the prospectus and explores all possible portfolios the manager may have held within these constraints. It then compares actual manager performance to these opportunity sets.

This approach unshackles managers from being compared to an index. Instead, they are measured against their opportunity set. Significantly, the metric also takes care of the “free pass” problem, when benchmarks are the basis for comparison.

Tom’s firm AthenaInvest has developed a similar approach that evaluates fund performance relative to that of a strategy peer group.

This technique can also be applied to asset allocation and other portfolio decisions. For example, investing $10,000 in the S&P 500 at the end of 1950 would have generated $9 million by the end of 2016, while an investment in T-Bonds would have generated less than $500,000. The $8.5 million “left on the table” is the true risk, not the increased volatility of stocks over this period. The chance of a real loss should be the risk measure used in making such decisions, not the bumpiness of the ride. Viewed in this light, bonds are far riskier than stocks for building long-horizon wealth.

No Simple Solution

As Tom has told his investment classes for years: Academics have little meaningful insight into measuring risk. This hasn’t exactly endeared him to department colleagues or to some of his students. In essence, he was saying that the research on measuring risk conducted at hundreds of academic institutions over the decades has largely been fruitless.

No discipline likes to admit such monumental failure. But this is where we are in finance today.

Forty years ago, measuring investment risk was largely the purview of sell-side and buy-side analysts. Today, we have come full circle: Once again analysts are the go-to source for assessing risk. It may be frustrating that their analysis cannot be summed up in a single number. But we tried a model that did just that and it failed.

Measuring investment risk is a messy process and is not amenable to a simple solution.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/valentinrussanov

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23 comments on “The Active Equity Renaissance: New Frontiers of Risk

  1. Chuck t said:

    I agree with your conclusion. There are certain things we just cant do. Defining all the risks and trying to measure the impact of those risks on an investment is a leap of faith. And trying to predict them is lunacy. Keep it simple with 1/N asset allocation and go enjoy your life.

      • Todd Meier, CFA, ASA, MAAA said:


        The actuarial profession is also highly caught-up in measuring risk and pricing risk loads based on volatility measures (covariance, short-fall risk, VaR, etc.) and spends an inordinate amount of time on the theory of parceling-out shared covariance among risks (should it be additive, subadditive, should if be variance-based or standard deviation-based?). The profession, like modern finance, has found itself lost deep within the woods at the midpoint of its journey. However, like in the stock market, this theoretical pricing of risk is largely inconsequential, because ultimately it is the market that is the arbiter, not the actuary or theoretician going through the motions of a pricing model in a spreadsheet.

        • Chuck t said:

          Experts in Insurance, Modern Finance, Political Science, Climatolgy etc. are all trying to do the impossible; predict the future. Perhaps its overconfidence bias at work. We can only infer so much from empirical data and then a black swan comes floating by, and more often then we think. Thats why insurance companies price their products with a huge margin of safety in their premiums as they prey on our anxieties. And thats why potfolio managers diversify.

    • Hi Chuck,

      I am not so sure I agree with your interpretation of the conclusion. The insurance business underwrites risks of all kinds and has for hundreds of years, and quite successfully for the most part. But the actuarial framework seems to elude the interest and attention of finance for some reason. Most business risks are within a fairly constrained set. At the business level they manage these risks, so why can’t an analyst identify them, too? Can’t a difference of opinion between business/credit and the analyst about specific risks be a source of value add/long position, or value remove/short position?

      Yours, in service,


    • …oh, and Chuck, I meant to ask you two questions: 1) what is the shape of your distribution; 2) beta has the same problems as standard deviation, so how are you rectifying those issues with 1/N asset allocation? And I guess a third occurs to me, are you advocating for 1/N exploration and production companies as diversification for a long-term equity investor?

  2. Brad Case, PhD, CFA, CAIA said:

    Hi Jason and Tom,
    This is an excellent article. I’ll quibble with some pieces of your argument, but your fundamental point–that investors have missed the BIG RISK of forgoing enormous upside in order to avoid the little risk of volatility–is an extremely important one. Investors hurt themselves by choosing low-volatility investments, and investment managers hurt investors by encouraging such behavior. I believe it’s that misdirection–encouraging investors to focus on short-term volatility, rather than helping them to realize upside outcomes–that explains the growth of the two most unfortunate forms of investment management, hedge funds and private equity (including private equity investments in my asset class, real estate), which together have deprived investors of literally trillions and trillions of dollars by sucking them into paying high fees AND forgoing upside outcomes in return for enabling them to use data that disguise their risks.
    My main question regarding this article is: what does it have to do with an “active equity renaissance”? Chuck T offers a perfectly sensible response: “keep it simple with 1/N asset allocation”–and, I would add, minimize the loss to your portfolio in the process by choosing the lowest-cost passively managed instruments available in the process. What’s wrong with that approach?

    • Hi Brad,

      See my response to Chuck. But to your point about real estate. At the individual asset level, a shopping center in some neighborhood in some city somewhere, can you assess risk? How about if that shopping center is a part of a larger entity’s portfolio of real estate assets, is it possible to assess the risk in their portfolio, or do you just use a single measure, the fluctuation in its securities price relative to a mean (i.e. beta)? I think a better understanding or risk by research analysts and portfolio managers is a rich source of alpha, either harvesting or loss avoidance. What could be simpler than evaluating risk the way the underlying business/credit does?

      Yours, in service,


  3. Tom Howard said:


    Thanks for your comment.

    What it has to do with the AER is exactly what you recommend: quit asking funds to manage short-term volatility and draw down and instead ask them to focus on the upside of investing.

    Industry gatekeepers employ a number of measures for evaluating and selecting funds that are based on volatility as risk: standard deviation, max draw down, high R-square, and the Sharp Ratio. These incent fund behavior that, as you correctly point out, dramatically limits investor wealth.

    Abandoning these volatility measures makes it possible for equity funds to become truly active.

    • Brad Case, PhD, CFA, CAIA said:

      That’s an interesting thought, Tom, but you’ve set up a decision between only two possibilities: (1) ask fund to actively manage short-term volatility and drawdown, or (2) free them to use active management in other ways. What about (3) abandon active management altogether? Perhaps that would be best, given that–as you and Jason pointed out in your earlier articles as well as in this one–active management decisions are frequently motivated by behavioral and cognitive biases that damage returns.

      • Hi Brad,

        I do believe that there are too many active managers, and especially those that have made many Faustian choices to gather AUM scale. See my series and the criticisms contained therein: Alpha Wounds. However, since you seem in a playful mood, let’s play with passive management. In particular, tell me that this possible marketing statement isn’t true: “Passive Management: Guaranteed to Underperform Your Benchmark, Always!” Active management when done well, and I agree that it mostly isn’t, has optionality to the upside.

        Yours, in service,


        • Brad Case, PhD, CFA, CAIA said:

          Hi Jason. Your statement is absolutely true: passive management is absolutely guaranteed (allowing for minimal tracking error) to underperform the benchmark by something like 0.03% per year (much less if you’re a large investor). That’s around three one-thousandths of the average annual return on stocks in excess of the risk-free rate of return, so it’s definitely not much. And you’re right, active management has upside risk–even when it is done poorly, never mind when it is done well. But investors can EXPECT to be worse off if they pay for active management.
          Yeah, I guess I’m in a playful mood, so think of it this way: playing Russian roulette with bullets in five of the six chambers has optionality to the upside. But I don’t expect to be better off because of it.

          • Hi Brad,

            In response to, “active management has upside-risk-even when it is done poorly…”: Upside volatility is not risk, downside might be. That is the point of this article, and the point with which you agreed.

            Separately, you are using historical underperformance of active management to make your point. Tom and I do not disagree with that result. In fact, our whole series is in response to that underperformance. We are making a philosophical point, whereas you are making a historical point; a point whose concession is one of our initial assumptions. Specifically, to borrow your colorful analogy, we would not pick up the gun you refer to because we know it is Russian Roulette, and whose lead manufacturer is MPT and its adherents.

            Yours, in service,


    • Thank you, Tom. I agree. Also, what I said previously, quality risk assessment at the business/credit level is where risk management should focus itself.

      Yours, in gratitude,


  4. Willie Brown, CFA said:

    While I agree that true risk to a long-only investor is the probability of R(t)<0% (or, a sort of semi-variance), however for the investor with the capability to short the market, standard deviation/volatility is the correct measure of risk, no? Interested in your thoughts!

    • Hi Willie,

      I still wouldn’t call that ‘risk’ – I would call that what it is, volatility. Most people that short stocks or other securities do so based on fundamental analysis. Your point is well taken, though…as a portfolio manager I flirted with a possible screening mechanism that calculated upside and downside volatility for individual securities. Ideally you want the one with large upside volatility divided by small downside volatility. However, I rejected this because I felt it just added a level of abstraction to my analyses. Instead I focused on the business risks that would affect my business’/credit’s ability to pay out a share of its operating earnings to me in whatever security I owned.

      At this juncture and time in finance we do not have good formal answers to the risk question. Instead, we are stuck with the unfortunate reality that Markowitz chose volatility for mathematical expediency in his paper from the 1950s. I think that is a poor excuse for not getting more sophisticated about these issues.

      Yours, in service,


  5. Gordon Ross, CFA said:

    The relevance to the active management renaissance of Jason’s excellent article is that even the brightest people with the best intentions can misuse data and quantitative tools. Investing, like life, will never be reducible to “do this, do that” by any amount of back-testing. Uncertainty demands continuing thoughtful attention.

  6. Stephen Campisi said:

    This is an excellent and thought-provoking article, as demonstrated by the comments and conversation this has already produced. Clearly, investors need to define their terms more precisely (as Voltaire stated) if this conversation is to be productive. I believe that many of the problems in communication we experience come from a lack of clearly-defined goals. Clients invest to meet their monetary financial goals, not to earn a return that beats an index or a peer group. (And don’t even get me started on the notion that benchmarks are an efficient way to invest!) But I digress… clients have a series of monetary goals, such that the purpose of the investment portfolio is to fund a series of regular withdrawals while preserving and perhaps growing the corpus. This has several important implications for investors which are generally ignored. These include inflation, taxes and fees, all of which change the risk/return dynamic that we use. They also affect our so-called risk measures. In the face of consistent withdrawals (which is a characteristic of almost every client portfolio) the third moment (skewness) becomes much more important than the second moment (variance.) To paraphrase one commenter in this conversation: “investors like variance on the upside.” We don’t want to monetize the market’s downside, and so we need to understand more about the pattern of volatility, and not simply the amount of volatility. So, it’s the PATTERN of returns that matters most when you’re withdrawing money. And it’s the ability to meet a client’s monetary goals that is the true measure of investment success, making this “liability” the true benchmark. It seems rather silly to debate statistical nuances when we are ignoring the job we have been hired to do. And frankly, it’s a failure of our fiduciary duty to replace performance metrics that address only the manager’s risk of being fired (i.e. comparisons to indexes and peer groups) with the true metric of success in serving the client: funding the liabilities. We need a different discussion, one that focuses on the clients who put their capital at risk by entrusting it to us to invest. They pay the bills and we work for them. At least we can do the job they hired us to do, and show them clearly that we are helping them to meet their goals with the capital that they have. The academic stuff can wait.

    • Hello Stephen,

      I agree with you, and all counts. I said as much in the recently authored “Future State of the Investment Profession” where I said that what clients really cared about was accomplishing their financial goals, not benchmarks, or outperformance. Thanks for introducing these ideas into the thread.

      I am very pleased that you found the piece excellent and thought-provoking.

      I am looking forward to more of your comments going forward.

      With smiles,


  7. Rosanne Howarth said:

    Thanks Jason for an excellent article

    I agree that the probability of capital loss should be the key focus of a risk measure. Time horizon is also important. It would be useful to find a measure that can express the likely recovery period from loss. Stated differently, a likely reversion to base rate measure.

    • Hello Rosanne,

      Thank you for taking the time to comment on the article, and I am pleased that you found it excellent. I am in agreement with you about the importance of time horizon. By the way, time horizon is also something that people do well, and better than do machines. So, in addition to being a bulwark for active managers vis-a-vis passive strategies, it is also a bulwark against machine learning algos/quants. Some of that future ‘performance’ is obviously reversion to the mean, but don’t forget that in the case of equities the mean line has a positive slope to it…meaning that there is both earnings growth and economic growth, too.

      Yours, in service,


  8. Muhammad Rahim said:

    Dear Mr. Voss,

    it was an absolute pleasure reading your article! I am most relieved to see something like this coming from someone who is such an integral part of the Institute. This article brings me hope that we may soon see some major overhauling of the CFAI curriculum. To specific parts of the curriculum addressing risk measurement and portfolio management.

    You see being a CFA level 3 candidate, I started having trouble accepting volatility as a measure of risk after hearing Warren Buffett talk of risk as the chance of permanent capital loss. Although I did not completely understand this perspective, at that time, however; I realized that I needed to start thinking about this topic seriously.

    Please understand that I have the utmost respect for the Institute as I believe that it is doing a fine job when it comes to learning (and updating its curriculum) from market practitioners and like any evolving entity is learning from it’s mistakes and growing each and every day.

    I am appearing for the CFA level 3 exam this June and after reading your article I am most hopeful that we will get to see a fresh perspective on risk and portfolio management coming directly from the institute, soon. I intend to review anything and everything the institute updates in the future, in this regard. I am sure the content will be top quality just like the body of knowledge (from the institute) which is second to none.

    wishing you all the best.

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