The relationship between risk and return is alive and well, even though in the past 10, 20, and 30-year periods (ending December 2011), it has looked more like this:
Widely accepted ways of measuring risk simply do a poor job of showing it. Risk encompasses the multitude of scenarios an investment could deliver, not the single path that ends up being measured afterward. In other words, volatility, standard deviation (and the many ways they are sliced and diced in risk management models) tells us what has happened, not what might have happened or could happen in the future.
In fact often times, the lower the volatility an investment exhibits, the greater the risk it carries (and vice versa). During turbulent times, investors buy assets they perceive to be safe (driving their prices up and making them riskier, all the while causing volatility to fall) and sell assets they perceive to be risky (driving their prices down to a point that makes them safe, while volatility goes through the roof). This is the basis of Warren Buffet’s advice “be fearful when others are greedy and greedy when others are fearful.”
This is an excerpt from our article “What color is your parachute?” published January 31, 2012