Practical analysis for investment professionals
20 April 2017

The Active Equity Renaissance: New Frontiers of Risk

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.

At the 70th CFA Institute Annual Conference, which will be held 21–24 May 2017, C. Thomas Howard will discuss ways that active equity mutual funds can be evaluated through behavioral concepts during his presentation, “The Behavioral Financial Analyst.”

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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

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Voss also sub-contracts for the well known firm, Focus Consulting Group. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: [email protected]

C. Thomas Howard

C. Thomas Howard is the co-founder, chief investment officer, and director of research at AthenaInvest. Building upon the Nobel Prize-winning research of Daniel Kahneman, Howard is a pioneer in the application of behavioral finance for investment management. He is a professor emeritus at the Reiman School of Finance, Daniels College of Business, University of Denver, where he taught courses and published articles in the areas of investment management and international finance. He is the author of Behavioral Portfolio Management. Howard holds a BS in mechanical engineering from the University of Idaho, an MS in management science from Oregon State University, and a PhD in finance from the University of Washington.

43 thoughts on “The Active Equity Renaissance: New Frontiers of Risk”

  1. Chuck t says:

    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.

    1. Tom Howard says:


      Right on!

      1. Todd Meier, CFA, ASA, MAAA says:


        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.

        1. Chuck t says:

          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.

          1. Hello Chuck,

            I agree with nearly everything that you wrote. I would add that securities analysts can also add in a margin of safety to analyses. I am a very big fan of margin of safety (see my post entitled, “Margin of Safety: The Lost Art” here on Enterprising Investor). Why? For black swans, human error, and other things that go FUBAR. By definition, the greatest risks are those for which there was no planning or accommodation. I cannot get perfect planning, but I can make an accommodation for imperfection.

            Perhaps you might find this meaningful, and here I am about to reveal an insight that I believe deserves to be a major area of research. Namely, I think that portfolio thinking, including MPT, in many (perhaps most (let’s get some data)) cases results in greater risks being taken on. How? If all you are evaluating are the variances and covariances, or if you think to yourself ‘this asset is the risk portion of my portfolio’ then you take on risks that otherwise may not make much sense otherwise. Here “no money down mortgages to first time home buyers who are at risk for losing their jobs” come to mind, for example. I could go on.

            Yours, in service,


        2. Hello Todd,

          Thank you for the additional color about the actuarial profession. As I said in response to another comment in this thread, business people evaluate risk very differently than those harboring a closeted love for mathematics. That is, they tend to think about the chance of loss, as well as prospective threats to aspects of a business. Numbers play into it, but so does creativity, and scenario thinking. Many large scale businesses do a fantastic job of anticipating, planning for, and taking advantage of, risks.

          Yours, in service,


    2. 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,


    3. …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 says:

    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?

    1. 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 says:


    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.

    1. Brad Case, PhD, CFA, CAIA says:

      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.

      1. 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,


        1. Brad Case, PhD, CFA, CAIA says:

          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.

          1. 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,


    2. 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 says:

    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!

    1. 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 says:

    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.

    1. Hello Gordon,

      Thank you for pointing these things out. This is a common refrain of mine.

      Yours, in service,


  6. Stephen Campisi says:

    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.

    1. 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 says:

    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.

    1. 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,


      1. Nick R. says:

        Hi Jason,

        Great article. It certainly provokes thought and discussion.

        As you pointed out, we are human and emotional. We are not the rational, homo ecomonmicus persons we ideally should be.

        Hindsight is 20/20. The fact is people need to sleep at night and not worry frantically about their ability to fund retirement, education and daily living expenses. Therefore, I think defining risk as short-term volatility is ONE appropriate measure because too much short term volatility in a portfolio could cause people to react irrationally and fearfully and abandon investing to their long (and short) term detriment. As advisors and investment managers, we are servicing humans, not machines.

        Regarding passive investing and ETFs, I use them to fund children’s 529 plans and some of my personal assets. I think they are a necessary part of a diversified portfolio as an efficient way to capture systematic market exposure. That being said, the utilization of passive investing is relatively new in the market. The use of ETFs is exponentially greater today than it was 10 years ago, and more so than 30 years ago. My concern is investors are getting a “free lunch” and many who have only started investing after the Great Recession (when the stock market has gone straight up with high correlations in equities) are, to borrow a phrase from Game of Thrones (and credit o my eldest, wisest brother on this anology), Children of Summer. So I am skeptical that ETFs are a new, fool-proof answer and passive investments are going to decimate the asset management business. A smart hedge fund guy I used to work with said “there’s a new in a life time crisis that happens once every ten years”. I could see ETFs being the catalyst to the next one. We will see. Markets work themselves out all the time.

        But we shall see and I thank you very much for your excellent work.



        1. Hello Nick,

          Your commentary is thoughtful in my opinion and adds to the thread. Thanks!

          I think Tom and I would argue that one of the most important roles of the adviser is to acknowledge clients’ emotions around risk. But to challenge them head on and ensure that we do not pander to them in preference to long-term capital appreciation and achievement of client goals.

          With smiles,


  8. Muhammad Rahim says:

    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.

    1. Hello Muhammad,

      Thank you for your exceptionally kind words…I feel them : ) My role at CFA Institute is to assist members in doing their jobs better, and I have very little to do with the curriculum that candidates see. I hope that the industry takes it upon itself to begin to explore risk in a more meaningful way going forward. Ironically, I tend to think going backwards, rather than forwards holds a lot of merit. What I mean by that is that business people evaluate business risk without relying upon volatility, and many of them do a fine job of anticipating risk, planning for risk, and taking advantage of risk. Hmmm. And therein likes a possible compass point for where we as an industry could go.

      Yours, in gratitude and service,


      1. Muhammad Rahim says:

        Hello Mr. Voss,

        I believe Warren Buffett, when compared to Modern Portfolio Theory, looks at risk in a very different light. I think he does not look at asset price volatility as risk at all. No. Price volatility is something that creates opportunity.

        Opportunity to buy more (when prices fall) and sell (in case prices rise too much above intrinsic value and there are better opportunities available). No, he thinks of risk in terms of any future event that would lead to a deterioration in the fundamentals of the business so that the earning (or cash generating ability) of the business falls permanently to levels that the price paid is no longer justified. Please, correct me if i am mistaken but this is, in my humble opinion, what he means by ”permanent capital loss”.

        I agree with you completely that business people are able to understand, anticipate and mitigate risk by understanding the underlying business dynamics. This is exactly what Mr. Buffett does best. He has studied certain businesses/industries (which he likes to call his circle of competence) over the decades to the point that he understands factors driving business and eventually stock performance quite well. (And yes there is a difference between the underlying business and the stock although the performance of both is mostly positively correlated in the long run but not necessarily in the short run.)

        The argument that stock performance is not correlated to the underlying business performance can be put to rest for good with this question:

        ”What would happen to the price of the stock if Coca-Cola stopped selling it’s drinks and other products?” (Sales is a business fundamental.)

        The answer is undoubtedly;

        ”The price would go down to zero and the company is likely to be liquidated.”

        So, if price volatility is not a measure of risk and it is important to understand the underlying business then what happens if Mr Buffett is unable to comfortably predict the future cash flows of a business operation? How does he value such a business?

        The answer to this is quite simple; ” He doesn’t.” Yes, you read correctly. He does not invest in businesses for which he is unable to forecast the cash flows. Hard to believe it’s that simple? I thought so too the first time I read this in one of Berkshire Hathaway’s annual letters to the shareholders. But this makes perfect sense if we consider what he has always stated regarding his circle of competence. That is ”do not invest in anything you don’t understand.”
        He is perfectly happy walking away from a deal he is unsure of.

        The question comes up if Mr. Buffett does not take asset price volatility or Beta (price volatility of a stock in relation to the market) as risk/measure of risk then how does he come up with the required rate of return?

        I am currently researching this very question and have not come up with a definite answer as yet but I think that he probably uses the build up method of some sort to come up with a specific required rate of return. The required rate of return would have to be the same for all assets. I know this is hard to digest especially for people who have always considered price volatility or Beta as a measure of risk but it makes perfect sense. I have heard a few people, who are close to, Mr. Buffett say that he uses a 15% return on all of his investments.

        Another risk mitigation method is the use of the concept of ”Margin of Safety” where Mr Buffett calculates the value of a stock and then discounts one third of the value to come up with an even more conservative method. This is his buffer in case things don’t turn out the way he had anticipated and his losses would be mitigated even more. It’s all simple to understand but not easy to implement.

        Thank you so much for taking out the time to read my comment.



        1. Hello Muhammad,

          Thank you for your extended comment. Yes, this is how I think about risk, too when evaluating a security for possible purchase or sale.

          Yours, in service,


          1. Muhammad Rahim says:

            Dear Mr. Voss,

            Since, we both agree that the way to understand business risk is by spending time in order to study an industry/business and develop a conceptual framework which allows us to understand the main factors that will drive performance in the future. By doing so not only do we develop a deeper understanding of how the business/industry operates but we also become aware of the risks associated with these business drivers and how they could negatively impact the business/industry and eventually our investments.

            I saw the CFAI ”industry guides” a few weeks back and was instantly hooked to them! (Excellent work by the Institute I must say!) I am sure you would agree that these are quite important readings, along with corporate filings, for anyone who wishes to understand and develop a deeper understanding of specific industries.

            As I am currently interested in specializing in analyzing and evaluating the energy sector (including oil and gas, coal, electricity and alternatives) I would like to ask if you believe there is value in going for a specialized study program such as the Energy Risk Professional (offered by GARP)?

            This program is designed to develop a candidates ability to understand how businesses operate in the energy sector as well as the risks associated with them so that one is eventually able to manage and mitigate risk.

            Your advice would be most helpful to me.

            Thanking you for taking out the time to read my comments and responding!

            Best wishes.


          2. Hello Muhammad,

            I am not familiar with that program, so cannot comment about its quality. I began my career as an E&P analyst, and ended up being a ranked analyst by Reuters (they rank buyside analysts), and I did not have the ERP designation. Instead, I studied the industry intensively and thoroughly read “Money in the Ground” and “Security Analysis and Business Valuation on Wall Street” by Jeffrey Hooke. Both prepared me very well for the industry. That said, designations are very important to some hiring managers, and so it may make a difference.

            I am sorry that I cannot be more helpful.

            Yours, in service,


          3. Muhammad Rahim says:

            Hello Mr. Voss,

            ”Instead, I studied the industry intensively and thoroughly read “Money in the Ground” and “Security Analysis and Business Valuation on Wall Street” by Jeffrey Hooke. Both prepared me very well for the industry.”

            Thank you for your recommendations. I am sure they will be invaluable resources in helping me understand the industry. Very kind of you for sharing your experience with everyone.

            Wishing you the best.


  9. Frank Mampaey says:

    The question you raise is interesting. It is worth mentioning that Markowitz, as early as 1959, devoted significant attention to using semi-variance as a measure of risk. That approach may still be valid and useful.

    1. Stephen Campisi, CFA says:

      Semi-variance is preferable to total variance as a measure of risk, given that risk should focus on “disappointing” returns that are below the expectation rather than “delightful” returns that are above expectation. An even better measure is risk relative to the investor’s “minimum acceptable return” as defined by Frank Sortino. If we must think of the client’s goal in terms of a return (rather than a monetary outcome) then the return that is expected to meet the client’s financial goals should be used to define and to quantify any risk measure. This “lower partial moment” approach to risk takes a little more work, but it is much more intuitive and relevant than these other academic measures of risk.

  10. Ellen says:

    “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”

    I dont have any assets, where permanent loss is possible, because if these assets would go to 0, world would not exist anymore… and opportunity costs of underperforming a Benchmark? I dont understand why this would be more relevant as volatility? BM is going down 50%, Strategy is going down 50% = Risk is 0?

    1. Hannes Kunz says:

      I also think that you compared apples with bananas. Of course you “risk” is just a flappy word, but still I would rather focus on the historical difference to the mean, as to any other measure the author described… that might be the difference between theoretical and actual working in that business…

      1. Hello Ellen and Hannes,

        You are thinking of risk only within a MPT framework, which is what this article is about (breaking free of that context), and this article fits within an entire series. Variation around a mean is not risk, it just isn’t. It was borrowed mathematically by Markowitz so he could author his thesis, and fast forward 70 years later and we are still using it as a flawed measure. Someone in this thread said that Markowitz realized the error of his ways and now uses a measure that is commensurate with loss only, and not gain, too.

        If you would like to intimately understand the issue then calculate standard deviation by hand, which I am guessing you have either never done, or have not done since you studied statistics. What you will discover is that variance, and its digits-copasetic twin, standard deviation, are weighted averages, not just averages. The result is that significant numbers above the mean (i.e. in our example, an active manager that kicks ass) look riskier because of the weight they receive. This makes no sense. How is outperformance, or even performance above a risk-free rate of return, or a required rate of return counted as risk? The insurance industry knows a thing or two about risk since they have been underwriting them for 500 years, and they define risk as the chance of loss, not as variation around a mean.

        My own preference for risk is to evaluate risk the way business people do – and I am not referring to the Mandarins of finance or banking. Here I am talking about the seemingly magical ability (if you are a lover of MPT) of business people to anticipate risks to their business models and build in to the business plan appropriate responses to anticipated risks, as well as their ability to respond to risks if they occur. Most militaries around the world have scenario plans for different events that may never unfold, but if they do they have an appropriate response. Not only that, but they alter force structure so that they can execute if one of the scenarios occurs. Why is it that when lives are the line, the risk of death or being conquered, militaries do not use standard deviation when assessing risk? In each of the example I have provided it is not any different than in finance. Human actors who have preferred outcomes recognize that the future may not unfold as they might like and they build a response to those possible non-preferred outcomes. No one except Markowitz and those who believe in MPT use standard deviation as their sole description of risk.

        Yours, in service,


  11. Chuck T says:

    Very good topic that a lot of people are showing interest in. The best thing I read on this subject a few years ago was Howard Marks memo to clients “Risk Revisited Again”. He talked about the limitations of variance as risk and how to deal with the uncertainty of not being able to predict the future.

  12. JY, CFA says:

    This is an embarrassing article to be posted on the CFA website, but then again the fate of this organization is closely tied to the fate of active managers, so I guess I shouldn’t be surprised by this content being produced.

    This article can easily be rebutted by two points of logic. The first claim of this article is that volatility is a poor measure of risk. The author says ‘look, volatility to the upside is good, therefore we’ve been measuring risk incorrectly’. Then he promotes his fund and suggests they measure risk appropriately by looking at ”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’.

    How did we make the jump here? How does the author expect the reader to just conclude that this is the appropriate way to define risk? Are readers expected to be unaware that downside deviation is a better measure of risk than standard deviation?

    The second failing of this article is to intertwine the idea that active managers will benefit from this new way of measuring risk. The implicit suggestion is that because we’ve been measuring risk incorrectly in the past, we’ve somehow distorted the incentives of active managers and led them to under perform. Poor guys, it was the investors fault all along!

    Nope, no matter how you try to spin it, active managers have historically, recently and will in the future under perform. I understand that your careers depend on you not accepting this premise, but you’re harming your investors and their families along the way.

    1. Hello JY,

      Thank you for engaging with this ’embarrassing’ content. I appreciate the time you have taken to elaborate your thoughts. In response…

      I am not sure asking investors to define risk and to consider risk as every other person on the planet does – including, and especially, the insurance industry – is embarrassing. More embarrassing is that our industry continues to believe that because something can be measured statistically, that is the best and only way to predict or anticipate that thing in the future. As the comment thread here suggests, even Markowitz has abandoned the foolishness, of at least, standard deviation as a proxy for risk.

      As for your claim that I am promoting my firm, a quick bit of due diligence on your part would reveal that my firm is CFA Institute. Another part of due diligence on your part would reveal that less than half of our members make their living as active managers; approximately 40%, in fact. Our Charter is held by over 300 job titles, including many who I know support your point of view. But a part of the beating heart of the CFA charter is principled disagreement. Ironically, CFA Institute is routinely lambasted for its defense of MPT. So your comments are, in some ways, really nice to receive, and an indication that these articles are in service to our mission.

      I sense in your response a rejection of the article because it does not proffer data. Correct? In my Alpha Wounds series I linked to my masters thesis work in which I demonstrated that when active equity and active balanced funds are evaluated, with Sharpe ratios that the classic result holds: two-thirds of active managers underperform. Yet, when downside volatility is included in the denominator instead that the reverse result holds, two-thirds out-perform.

      Next, as was mentioned in this thread previously, we concede the historical point. We offer a diagnosis for some of the ways active management went astray, and then offer prescription. This prescription is based on data, and in our series we have repeatedly linked to it. Both Tom and I acknowledge that we are making philosophical points. Your contributions for how to help end clients are welcomed. In fact, that is one of the lovely things about The Enterprising Investor: we encourage our readers and authors to engage with one another.

      As for the ‘jump’ you refer to…from my above responses it should be less jarring for you as most of the connections are laid more bare. I believe volatility does not measure risk, but instead is a weighted average around a mean. Break out a calculator and do this by hand and you will see this is not supposition on my part, but mathematical reality. Use of standard deviation made the math easy circa 1950-1985, but we no longer need to rely on such metrics. If you insist on describing risk quantitatively, then ensure that your measure measures what you believe it does. But, for me, and based on my experience as a former portfolio manager of some success, risk is better evaluated the way business leaders evaluate risks. Also, is there language in this article that indicates to you that we ask for a final verdict? Instead, Tom and I have routinely said, “What the industry is doing doesn’t work for end clients. How can we make it better?” In other words, we value your opinion.

      I am not a believer in false absolutes, like the one that you use, “no matter how you try to spin it, active managers…will in the future under perform.” The reason is that to do so is a misunderstanding of the meaning of the word and concept of ‘absolute.’ I think you are making, instead, a probability argument, and you mean there is a high probability of active management failure. Yes?

      Do you believe that some business leaders can better steer their businesses than others through their intelligence, wisdom, and efforts, or is business performance also random? And do you believe that publicly traded securities prices will eventually reflect the performance? If so, then why would it be impossible for a person to identify superior management engaged in executing business plans in a superior way? And to Tom’s points here and over the years, so you think there is predictability in securities price volatility? If so, then good predictions of volatility would be a good basis for constructing portfolios, too. If, on the other hand, and this is important for you to acknowledge, you believe that securities price volatility (measured by standard deviation) is random, then why would you use it as a risk measure, or to evaluate the performance of investment managers? Otherwise it is a tacit admission that managers should not be held accountable for it, since the results are random. You cannot have it both ways. If securities returns are random, then the time series of standard deviation for securities and portfolios must be, too.

      Yours, in service,


      1. JY, CFA says:


        You are promoting your prior fund, my apologies. Thanks for clearing that up.

        So only 40% of charterholders make their living off of active management? You’re right, I stand corrected, the institute definitely doesn’t have it’s fate tied to the future of active management or any incentive to promote articles promising a bright future for stock and bond pickers.

        Your masters thesis also claims that 87% of non-us equity managers outperform their benchmarks when measured by the Sharpe ratio. That’s all I needed to see to know that these numbers are incredibly outdated and no longer relevant. You should probably stop referencing a 20 year old analysis that only covers a 10 year time period. If you were to replicate that exact same analysis, instead of using 1987-1997 use 1987-2017, I guarantee (I’m a fan of absolutes) that the results are significantly less favorable for active managers, regardless of if we’re talking sharpe, treynor, sortino, etc.

        Plain and simple, downside deviation is more than adequate as a risk measurement for broadly diversified investments. Anyone who reads this article and is unaware of the difference between standard deviation and downside deviation has been educated and is better off now. That is the real service of this article. However, the implication that an alternative method of measuring risk will improve outcomes for active managers is false logic.

        1. Hello again, JY,

          Thanks again for your comments. First, if you consider mentioning my former employer of 12 years ago in passing is promotional. Then I could argue by the same logic that you are shilling for yahoo because you use a yahoo e-mail account. I think that is pretty flimsy. In my case, I highlighted my work as an investment manager because I believe that experience and success in the industry are relevant to the conversation.

          My research does not show that 87% of managers, as measured by a Sharpe ratio, beat their index. Sharpe ratios use standard deviation as their denominators. We have been over this before, and the research does not state what you are stating. Is the research outdated. Perhaps.

          Separately, Tom and I have authored an entire series of posts about how to improve active management. Not just this singular post. Two more are forthcoming. Additionally, you should read my series entitled Alpha Wounds to see if you get a more comprehensive view of what Tom and I consider to be a systemic problem.

          I do believe that using different risk measures than standard deviation, or semi-standard deviation can improve the returns of active managers. But so long as most are evaluated in that way, and manage their funds that way we won’t have the ability to test the theory out. And that is a part of what Tom and I are discussing. Additionally, as we have said throughout this series. We hope to spark a discussion about how to improve active equity.

          Next, I never conferred with any member of CFA Institute to write this series. Nor have I ever conferred with any member of management to author any of my pieces. As writers for Enterprising Investor, we are not held in check by a business plan mandate. You might want to peruse this post I authored less than a year ago before you draw another absolute conclusion: This is pretty strong proof to the contrary about your contention. Additionally, I can tell that you are relatively recent reader of The Enterprising Investor because for years we have featured articles from both sides of the passive vs. active debate.

          Further, if you look at the roster of authors for out site you will see at least several hundred authors. Almost all of those are outside contributors, and not employees. The platform is open to you as well, and you don’t even have to have a CFA charter. If you accept the challenge, as many who have authored a pro-passive management article have, and submit an article that meets our guidelines, and your writing is understandable and compelling, and your logic consistent, then you, too could be a writer for The Enterprising Investor. I am not one of the editors. So if our openness to your point of view is not evidence that we are not shilling, then can you be satisfied? You can find our requirements by clicking on the contributor tab at the top of the page.

          Last, you did not answer the questions I asked you in my previous comments. I invite you do so, again.

          Yours, in service,


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