Citigroup Inc (C), American International Group Inc (AIG): When Intelligent Investors Do Dumb Things

But before LTCM’s blowup, the fund was known for one thing: low volatility. A 1996 article in Institutional Investor describes it like this: “Before August, when returns dipped 0.24 percent, LTCM had not had a down month since February 1995, and only six down months in total.”

And the fund’s Sharpe ratio was an amazing 4.35, meaning it was earning big returns with low volatility. “If a fund manager can sustain a Sharpe ratio of 1, he is doing well,” the magazine wrote. “But a Sharpe ratio of more than 4 is off the charts.”

The article closes by asking, “how long can they produce those kinds of returns before suffering some spectacular crash?”

We now know the answer: about a year.

LTCM was a glaring reminder that past volatility is a terrible measure of future risk. Yet we still obsess over volatility, convinced that it tells us how safe an investment is.

Nassim Taleb describes using volatility as a measure of risk as the “turkey problem.” He writes in his book Antifragile:

A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys “with increased statistical confidence.” The butcher will keep feeding the turkey until a few days before Thanksgiving. Then comes that day when it is really not a very good idea to be a turkey.

So if volatility isn’t a good measure of risk, what is?

I like the Berkshire Hathaway Inc. (NYSE:BRK.A) credo:

Warren Buffett: “Risk comes from not knowing what you’re doing.”

Charlie Munger: “Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.”

Buffett’s definition of risk is most applicable to individual investors. If you don’t know what you’re doing, you are rolling the dice at best. Add in fees, and you will you almost certainly lose.

Mugner’s definition is more relevant to institutional investors. For pension funds, the biggest risk is not suffering s down month or a bad quarter; it’s that, over a 20- to 50-year period, they won’t earn high enough returns to cover their obligations.

But for both groups, past volatility tells you very little about future risk. “Using volatility as a measure of risk is nuts,” Munger says.

Check back every Tuesday and Friday for Morgan Housel’s columns on finance and economics.

The article When Smart Investors Do Stupid Things originally appeared on Fool.com is written by Morgan Housel.

Fool contributor Morgan Housel has no position in any stocks mentioned. The Motley Fool recommends American International Group (NYSE:AIG) and Berkshire Hathaway. The Motley Fool owns shares of American International Group, Berkshire Hathaway, and Citigroup and has the following options: Long Jan 2014 $25 Calls on American International Group.

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