Measuring Investment Risk: Volatility, Liquidity & Private Market Risk for High-Net-Wealth Investors

Why volatility alone isn’t true investment risk

A central question for any investor is how to measure risk. The canonical measure used by investment managers is volatility. While this is a helpful quantitative tool, it does not holistically encapsulate the risk that investors experience. 

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Learn how personalised risk profiles influence portfolio design and investor comfort.

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Two investments, same return, different risks

Consider two investments: Investment A and Investment B. You purchase both today, and each has the following characteristics: 

• Investment A increased 10% in value over the past 12 months. During the next 12 months that you hold it, it increases a further 15%.
• Investment B decreased 10% in value over the past 12 months. During the next 12 months that you hold it, it increases 15%.

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In which investment are you taking more risk? Strangely, it is impossible to know based solely on this information. Past performance and price, in isolation, is not a reliable indicator of future risk. True investment risk is multifaceted.

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Understanding risk requires planning for investment timing and outcomes, not just past returns.

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Consider this counterintuitive point: even after selling either asset and thus realising a 15% gain, we still cannot definitively state how risky each investment was. Risk, in exact quantities, is ultimately unknowable; because the market is a complex, dynamic system, where the sheer number of interconnected variables prevents precise forecasting. What investors can do, is estimate the amount of risk they are taking by assessing the characteristics of each investment on its own merits.  

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What risk is not

Risk is often mistaken for other related concepts. Here are some things that are not risk:

• Risk is not only volatility. Volatility is a statistical measure of dispersion, quantifying the deviation of returns around a mean. Crucially, investors do not perceive upside volatility where they make money on the upside as a risk. Investors view this as desirable, not risky. 
• Risk is not a single number. No single metric can capture its true nature. While quantitative estimates are useful, risk has fundamental qualitative dimensions that numbers alone cannot describe. 
• Risk is not a simple price paid for linear returns. There is well-compensated risk and poorly compensated risk. An example of the latter might be 0-day-to-expiration (0DTE) options. For most investors, this represents an asymmetric risk where the probability of total loss is high, and the position is often purchased from a counterparty with a significant advantage.

A balanced approach, like diversification, can help mitigate multiple risks simultaneously.

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Then what is risk? 

For most high-net-worth (HNW) and ultra-high-net-worth (UHNW)investors, risk is primarily perceived as the probability of a permanent loss of capital. ‍

Because the relationship between risk and return is not linear or proportional, investors must approach the market probabilistically. Accepting more risk means accepting a wider range of potential outcomes, both positive and negative.

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Taking a long-term investment perspective can help mitigate some of this uncertainty.

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To further complicate the question of risk, the rise of private markets has introduced additional vectors of risk, primarily liquidity risk and risk of underperformance. These risks do not involve loss of capital, but rather a risk that returns will deviate from markets in a negative manner.  

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What are the risks outside of negative returns?  

• Liquidity risk: The risk that an investment manager is not able to return capital in the short term. Most common in private markets, as the manager may not physically have the liquidity to honor withdrawal requests.  
• Risk of underperformance: Private markets are by nature slow to re-price their investments and securities, typically requiring a new investment from an external party or an asset sale. Public markets re-price every day, and as such, may be faster to reflect positive investment performance. In periods of exuberance, this can cause a substantial performance gap between private equity / VC and public markets that can last quite some time. Investors may wish to consider this risk, particularly if benchmarking performance for their portfolio against public markets. 

Private capital, even venture capital, comes with unique risk-return profiles worth considering.

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How can I effectively manage the risks most pertinent to me, as an investor?  

The most important element in managing risk is cognizance – are you aware of all the relevant risks which apply to your investment, and are you comfortable taking each type of risk?  

Giving your portfolio the best chance of success

I would posit two final thoughts for you – there are two common factors in the best investors I have worked with throughout time.  

• The first – they have understood their own tolerance for downside volatility. You do not have to have an unending appetite for volatility to have strong, positive investment returns. They do not capitulate during periods of negative performance and are comfortable purchasing assets once prices have fallen.  
• The last – they have given their private investments time to work. Understanding that private market returns rely on exit valuations, and are lumpy, they have been comfortable to let their PE and VC managers utilize their time horizons effectively.  

By understanding each vector of risk, not overcommitting on your personal volatility tolerance, and giving your portfolio time, you give yourself the best chance of super brisk-adjusted return.  

If you’re interested in learning more about the possibilities for your portfolio, please don’t hesitate to reach out!