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A 401k Fiduciary Dilemma: The Risk of Using Volatility to Define Risk

May 28
02:34 2014

“Bomb patterns?” General Peckem repeated, twinkling with self-satisfied good humor. “A bomb pattern is a term I dreamed up just several years ago. It means nothing, but you’d be surprised at how rapidly it’s caught on. Why, I’ve got all sorts of people convinced I think it’s important for the bombs to explode close together and make a neat aerial photograph. There’s one colonel in Pianosa who’s hardly concerned any more with whether he hits the target or not.

 Catch-22, Joseph Heller

Like the top officers in Catch-22, the leading thinkers in the financial industry have long used the elegance of statistics – specifically, standard deviation as a measure of volatility – to frame the definition of risk. It worked so cleanly on the 209720_7945_bombs_away_stock_xchng_royalty_free_300blackboards of academia that it just had to be used in the boardrooms of America.

There was only one problem.

The theory was wrong.

To paraphrase our friendly physicist Richard Feynman, “a guess that is wrong is wrong, no matter how elegant, no matter who made it.”

And that’s a problem for 401k plan sponsors who rely on the investment industry to design menu options and advise participants. More importantly, if the old paradigm is dead, what new paradigm has replaced it? To begin to answer this question, we need to get a better idea of how this problem started in the first place. It begins with a familiar phrase, one that launched the advent of Modern Portfolio Theory (MPT) in the 1950s: “Risk and Return are related.” This is the relationship Harry Markowitz famously wrote of in his groundbreaking treatise “Portfolio Selection” (Journal of Finance, 1952) even before Bill Haley and the Comets took their turn rocking around the clock.”

To dig deeper on the risk-return relationship, read: “401k Plan Sponsor & Participant Primer – The Risk-Return Tradeoff

Oh, those were happier days back then, the greatest generation having just won World War Two, the same “good war” Heller would reference a generation later. The big theme of the Allies’ success in the second World War revolved around such words as “logistics” and “operations.” Everything was reduced to numbers, and, with the world about to be thrust into the Sputnik Era, it didn’t take much to transfer portfolio management from a droll accounting exercise to a formula-laden scientific enterprise.

As we all know, formulas (or “formulae,” for those who have been blessed with an education in the Latin language) contain, in addition to various mathematical operands, loads of numbers and variables (variables being merely numbers in disguise as letters). Everyone could easily pick out the number we needed to use for “return,” but folks had a devil of a time identifying the right number to use for “risk.” Finally, Markowitz discovered the solution.

But computers back then weren’t powerful enough for him to use it, so he had to settle on standard deviation. William Sharpe, who along with Markowitz would later win a Nobel Prize for their work on MPT, in his own seminal paper, admits (albeit in an obscure footnote hidden deep in the article) “Under certain circumstances, the mean-variance approach can be shown to lead to unsatisfactory predictions of behavior. Markowitz suggests that a model based on the semi-variance would be preferable; in light of the formidable computational problems, however, he bases his analysis on the variance and standard deviation.” (Sharpe, W.F., Capital Asset Prices: A Theory of Market Equilibrium under Considerations of Risk, The Journal of Finance, Volume 19, Issue 3, September 1964, 425-42.)

There you have it. From the beginning we understood the lower partial moment (i.e., that part of the standard deviation below the mean) was a better measure for risk than standard deviation. Standard deviation equates missing the goal at the same level of risk as surpassing the goal. Using the full standard deviation didn’t make sense to Markowitz at the time (and presumably still doesn’t), but, computers being what they were back then, was all he could settle for.

Soon thereafter, standard deviation became the universal measure of “risk.” Eventually, it found its way in portfolio optimization programs. You know these, don’t you? These are the programs they use to determine a recommended asset allocation. Are you starting to connect the dots here? Do you begin to see why so much we see in the financial industry is defective? It’s because academia and industry have constructed the main apparati (happy, Latin lovers?) based on a flawed theory.

How and why did standard deviation fall from its exalted heights? “Volatility as a description of risk is inadequate for many reasons,” says Matthew B. Boersen, Partner at Straight Path Wealth Management in Grand Rapids, Michigan. In a nod to Markowitz’s original concerns, he says, “First, volatility by its definition describes both upside movements and downside movements. Theoretically, a stock or fund could have a high volatility measure for a 1 year period, while never dropping below the original 52 week low. Because advisors use volatility to describe risk, participants equate volatility with negativity, even if it measures both positive and negative movements.”

Read more on why volatility fails to measure true risk: “The 401k Plan Sponsor’s Dilemma – What’s Wrong with ‘Risk’

“Volatility fails two-fold,” says Kevin Conard, Co-Founder of in Overland Park, Kansas. “For starters, it has a negative connotation. When an investor hears the term ‘volatility’, he instantly assumes it is dangerous scary-roller-coaster-ride of an investment. When, in fact, volatility is a 401k investor’s best friend – allowing them to dollar cost average into positions in their account. Secondly, volatility fails to frame risk correctly. Risk should be defined as the failure to build up a 401k/retirement account that will sustain an independent retirement that out-paces inflation – that is true risk.”

Jamie Hopkins, Esq., Assistant Professor of Taxation in the Retirement Income Program at The American College in Bryn Mawr, Pennsylvania, and Associate Director of the New York Life Center for Retirement Income says, “Volatility fails as a real-world definition of risk for the regular investor because it is too narrow. Volatility shows us one level of risk but does not explain all of the concerns and threats to the investor. For example, a product might have low volatility but no liquidity. This represents a risk to the investor that does not show up in the definition of risk when defined by volatility.”

Perhaps the greatest sin of volatility was its failure to act as advertised in the two recent market crises. Joe Gordon, Managing Partner at Gordon Asset Management, LLC, in Raleigh-Durham/Chapel Hill, North Carolina, says, “You can back test all you want but we tell them to go back to 2000-2002, and 2008 and recall how poorly equities performed. When bad things happen, as in 2008, most all correlations approached one.”

Boersen concurs. He says, “Volatility measures have a bad track record of guiding investments and understanding true risk. For instance, volatility measures were at all-time highs in March of 2009, scaring many participants into pulling money out of the market at exactly the wrong moment. I actually have a client whom I met in 2011, that when reviewing his 401k statements, we discovered he had called in an investment change from equity funds to cash in his 401k on March 9, 2009… ‘the day the market bottomed.’ Conversely, right now volatility measures are very low. As I write this, the VIX is currently trading under 12, far below its normal trading range, signifying very low volatility. However, many analysts think there have been few times when the market has been more dangerous to invest in.”

Since the rise of behavioral economics over the last dozen years or so, many in the academic world, especially younger researchers, see MPT and, especially, the use of standard deviation or volatility to define risk as well past their expire date. “The financial services industry has for far too long held onto the traditional academic definition of volatility and risk when talking to clients about their investments and portfolios,” says Hopkins. “While these definitions have their place, it is often not in discussions with clients. Instead, the industry needs to continue to separate risk from volatility as the only measurement stick. Instead, risk should be viewed as the threat to future unwanted events or changes. In some areas the industry drives academia and in others, academia drives the industry. Unfortunately, the traditional definition of academic portfolio risk is out of date and does not accurately represent client concerns.”

Although most modern academics generally recognize volatility as an inappropriate proxy for risk, many financial service firms continue to reference it, if not use it outright. For example, Katie Stokes, Director of Financial Planning at J.E. Wilson Advisors, LLC in Columbia, South Carolina believes “Defining ‘risk’ as volatility is not inherently incorrect, it just isn’t very helpful to the average (or even above average) investor. So much focus is placed on volatility because the impact can be great when not handled correctly.”

“Unfortunately the industry is slow to change. I think it’s a term that has become part of the common vernacular and no one has challenged or identified what true risk is for an investor that might live 30 years into retirement,” says Conard.

That MPT remained unchallenged for almost two generations and that it had been born from such mathematical rigor makes it hard to replace. Anthony Alfidi, CEO of Alfidi Capital in San Francisco, California, says “The academic definition of volatility has lasted so long because there is no widely accepted replacement that carries a similar statistical validation. Stochastic alternatives are [only now] beginning to receive validation in academic research.”

Some in the financial community are not so charitable. The fact is MPT techniques have been incorporated quite successfully into sales literature over the decades. Some see the industry as reluctant to give up on such an effective sales tool just because it doesn’t work as advertised. Leonard P. Raskin, of AEP Raskin Global in Hunt Valley, Maryland says, “I believe the industry doesn’t care what the investor knows or doesn’t know. They simply want to accumulate as much money under management as possible to maximize fund company fees.”

Joseph Carbone, Jr, Wealth Advisor and Partner at Focus Planning Group in Bayport, New York says, “I think it’s one of things in our industry that is not always developed or marketed with the novice investor in mind. Many times our industry and advisors do not understand what the retail public really wants.”

Matthew Grishman, Co-Founder, 401kMasters, a subsidiary of Gebhardt Group, Inc. in Lafayette, California must have just finished reading Catch-22 when he answered our question. He says, “We believe the industry has held onto its beliefs about volatility for its own self-interest; that interest is for the benefit of collecting fees. The industry has promoted a ‘buy and hold’ strategy as the only way to manage volatility for this very purpose. They have leveraged the 24 hour media cycle as a way to keep volatility in front of millions of investors to promote their fee-collecting agenda. ‘Stay invested through volatility because you don’t want to miss the best days of performance.’ Although we agree buy and hold has worked for investors sometimes, during 2 extended bull markets (post WWII and 1982-2000), it was also the cause for so many investors to lose 30-60% of their life savings in 2008-2009. Despite investor losses, the industry kept promoting buy and hold so investors remained invested, allowing the industry to continue collecting fees.”

Ironically, it may be inertia alone keeps this ball rolling. And that inertia comes in the form of your friendly neighborhood compliance department. If ever there was a need to exemplify “herd mentality,” compliance would fill that bill quickly. It’s tough to say “no” to a Nobel Prize winning concept. It’s just as difficult to say “yes” to the latest finance professors have to offer. Boersen says, “I think compliance concerns have driven the over-utilization of substituting volatility for risk. Whether it be a plan custodian putting together education literature, or an advisor putting together an education presentation, compliance restrictions many times limit the usefulness of adequately describing risk and volatility. Because of this, advisors many times have two choices for words when talking about investment downsides, either ‘risk’ or ‘volatility,’ as most compliance departments accept those terms.”

Travis Freeman, President of Four Seasons Financial Education in St. Louis, Missouri, see the same thing. He says, “The industry as a whole cannot grasp a more consumer-friendly definition of volatility due to legal reasons. For example, one may explain the negatives of volatility as the risk of losing money. However, that doesn’t register with most people. What does register is providing a hard number, such as a dollar amount. For example, explaining volatility and standard deviation as ‘a 67% chance of losing or gaining as much as $50,000’ makes much more sense to the lay person. However, I cannot imagine any compliance department in the US allowing this to go to print.”

The use of terms like “volatility” or “standard deviation,” even if used properly, fail to connect with the typical investor. Conard says, “Most investors define risk as the loss of their portfolio. We reframe the problem. We help them understand that showing up at THEIR retirement party without enough assets to sustain an independent retirement is the true risk.”

In addition, risk comes in many flavors, not the one implied by a single statistical number called volatility. Hopkins says, “When talking to investors about risk, specific risks need to be addressed instead of talking about just portfolio volatility risk. For example, liquidity, loss of spouse, sequence of return, and public policy risk all need to be addressed. As such, it is important to rank and gauge the investor’s risks. If the loss of one spouse due to an early death would require significant withdrawals from the portfolio this risk needs to be understood and addressed to minimize potential losses. Lastly, it is crucial to make sure clients know that when you deal with one level of risk, you often exacerbate another area of risk. As such, in the real world investors need to be comfortable with some level of risk, whether it is volatility, inflation, or liquidity.”

Interested in learning more the different definitions of “risk,” then read “Investment Risk and the 401k Fiduciary: An Overview of Components

Robert C. Lawton, President at Lawton Retirement Plan Consultants in Milwaukee, Wisconsin says, “Volatility is one aspect of risk. There are many others. Depending upon the investment, political, legislative, currency, economic, corporate, industry and other risks might be more important to consider. Investors who characterize risk in terms of volatility only may be missing the larger picture.”

“The definition of risk is too narrowly defined by volatility. For many investors, longevity, inflation risk, withdrawal risk, and basic asset allocation risk may be more important factors to financial security and success,” says Dan Dingus, President and Chief Operating Officer at Fragasso Financial Advisors in Pittsburgh, Pennsylvania.

Unfortunately, advisers cannot reiterate a cornucopia of risks to most investors. Investors demand the simplicity of a single number, a simplicity once provided by using standard deviation to measure risk. Maybe, though, the answer doesn’t lie in the risk part of the equation. Maybe the answer can only be found in the other half of the equation that started this whole movement.

Stay  tuned next week when we reveal the new paradigm. Same time. Same channel.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the “one portfolio” concept (as well as leaving room for those few remaining do-it-yourselfers).


About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


  1. Anthony Alfidi
    Anthony Alfidi January 26, 01:35

    Christopher, thanks for quoting me on volatility. The standard definition definitely needs a 21st century update.

  2. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author January 26, 10:50

    Much obliged for your input – and totally agree with you on updating the definition. We all need to try.

  3. Chuck Self
    Chuck Self February 06, 12:32

    Excellent piece, Chris. For ten years, our organization has been saying that the typical mean-variance optimization progress was used by Markowitz because he could prove his theory with hand calculations. Although we have more computing power in our phones than he had in total available to him, we are still using these outdated processes. Although there are many ways to come up with better implementations for MPT (and I think the theory is sound), we implement MPT creating efficient frontiers that use negative semi-variance as the risk measure. We think that this better aligns the results with the behavior finance realities of investing.

  4. Norris Edmonson
    Norris Edmonson February 07, 15:04

    Thanks for pointing out this article, Christopher. Once again you have brought to my attention a worthwhile article I would have otherwise missed. I have to agree that we have long tried to use mathematical statistics, garnered from patterns ferreted out of historical investment activity, to harness meaningful tools. We believe these tools will somehow divine answers to future events or patterns of activity that are subjected to more market, political, climate, legislative and spiritual forces and manipulation than we can possibly comprehend in a timely manner. I think that we, as individual human beings, find a need to separate what makes sense from nonsense…and we need to be able to explain them to our clients. …and you know, if we don’t use these tools, it might be hard to explain to a court why we ignored recognized and generally accepted industry practices that were “proven” by a Nobel Laureate.

  5. jim kaffen
    jim kaffen February 10, 12:00

    Please visit our website. I believe Dr Sortino, whose ratio is frequently used(Sortino Ratio which he has denounced) provides the answers you are seeking. For over 3 decades Dr. Sortino has been banging on the table that risk is not volatility, risk is not achieving ones financial goal. It is Dr. Sortino who has enhanced MPT. We refer to the enhancement as Post Modern Portfolio Theory and information on this theory can also be obtained at

    ps. there is now a new Sortino Ratio that Dr. Sortino created to replace the old one but I’m having a hard time convincing people, that Dr. Sortino knows what he’s talking about!!!!

    James Kaffen
    Sortino Investment Advisors

  6. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author February 10, 12:14

    Jim, thanks for the comment. I’m aware of the “Sortino Ratio” from the Forbes article of 15+ years ago and the surrounding “Post-Modern Portfolio Theory” controversy (on both sides of the aisle, by the way). It’s one of the reasons why I don’t refer to that term.

    My question is, if he’s denounced it, why are you still using it? Is it useful in terms of at least being a good approximation? Is the resistance from people on his new Ratio fallout from the fierce battles of the 1990s on this issue? It might make a good story if I can find out something that hasn’t already been covered.

  7. Joseph Carbone, Jr
    Joseph Carbone, Jr June 23, 14:36

    Hi Christopher,

    I just noticed you quoted me in your article. Thank you very much =)


  8. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author June 23, 14:43

    Thank you for offering your quote!

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