Risk

Rethinking Risk: Volatility, Opportunity, and Wealth Building

“I like putting all my eggs in one basket and then watching the basket very carefully.”

- Stanley Druckenmiller

Risk is a crucial concept for anyone who uses money as capital to grow more money.

What’s interesting is that if you ask different market participants what risk means, you’ll get very different answers. However, most will equate risk with volatility.

Volatility is often seen as a synonym for risk because it reflects the possibility of losing a large portion of capital when markets move sharply against you. That’s why smart people came up with measures like the Sharpe ratio, which considers not only raw returns but also the amount of volatility involved in generating those returns. For example, a strategy that produces only half the return of the benchmark, but with a third of the volatility, would still have a better Sharpe ratio. This also implies that such a strategy could be amplified through leverage to match or exceed higher-return strategies.

But this brings up a key question:

Is volatility really risk?

I would argue the opposite—volatility can be opportunity.

Time Horizon Changes Everything

It’s essential to understand where someone is in their wealth-building journey. For someone just a few years away from retirement, volatility should indeed be viewed as risk. A 60% drawdown just before retirement could be devastating.

But for someone still in the early or middle stages of wealth accumulation, volatility could represent a powerful opportunity to build wealth faster.

As I’ve said before, when it comes to long-term wealth, a high compounding return beats a high savings rate. (Formula of Wealth) That’s why I allocate a portion of my capital to high-risk, speculative strategies aimed at generating large raw returns. For this part of my portfolio, the Sharpe ratio is not a priority. I’m not concerned with large drawdowns if the ultimate outcome is a significantly higher annual growth rate.

This segment of my capital is not designed to deliver consistent, low-volatility returns over decades—that’s the role of my ETF-based retirement portfolio. The goal here is different: to turn a medium-sized portion of capital into a large amount, regardless of the volatility along the way. I’m focused on getting from point A to point B, not on having the smoothest ride.

The Problem With Treating Volatility as Pure Risk

Conventional wisdom promotes conservatism—and in many cases, that makes sense. But by automatically linking volatility with risk and seeing risk as something to avoid, many people limit their potential for outsized returns—especially during the early stages of their wealth-building journey.

Most great fortunes weren’t built from a diversified basket of ETFs. Just consider this: virtually every major company in the Nasdaq 100 employs thousands of people who are compensated in the form of company stock. These people aren’t diversified—they often have a huge portion of their net worth tied to one company. Likewise, some of the wealthiest individuals in the world built their fortunes by going all in on a single company or idea.

Dollar-Cost Averaging: Turning Drawdowns into Opportunity

Another major opportunity, especially for those in the early stages of wealth accumulation, is dollar-cost averaging. Think of a strategy like a stock: if it experiences a deep drawdown but still holds long-term potential for a strong reversal and recovery, that downturn becomes a prime opportunity to increase exposure at lower prices. Investors who are steadily allocating capital—month after month—can take full advantage of these dips. For those just starting out, where each contribution has a meaningful impact on the overall portfolio, this approach can create a significant edge. Ironically, while many investors chase high Sharpe ratios and low volatility, those who consistently buy into quality strategies during tough periods often position themselves for far greater long-term returns.

Concentration: Not for Everyone, But Not Always a Mistake

You can’t make generalized advice like "concentrate your portfolio" work for everyone. It carries a wide range of possible outcomes. Additionally, the mental challenge that comes with volatility should not be underestimated. Watching a portfolio swing wildly—especially during drawdowns—requires a strong mindset, discipline, and emotional resilience. For many, this psychological pressure can lead to poor decision-making, even if the underlying strategy is sound. But as someone becomes more experienced and knowledgeable, concentration can become a powerful tool for those seeking to generate superior returns.

As legendary investor Stanley Druckenmiller once said:

“I like putting all my eggs in one basket and then watching the basket very carefully.”

The following chart shows how adding more stocks to a portfolio reduces risk—but only up to a point. After that, additional diversification starts to dilute returns without meaningfully improving risk-adjusted performance.

Adding more stocks to a portfolio helps reduce company-specific (idiosyncratic) risk. However, the marginal benefit of diversification decreases with each additional stock. Market risk, which affects all assets, remains and cannot be diversified away.

In truth, markets are highly correlated. When markets crash, most stocks go down together. Diversification helps protect against company-specific (idiosyncratic) risk, but there are other ways to manage that kind of exposure—such as sizing positions, using stop-losses, or having uncorrelated strategies.

Distribution of Correlations Among the Largest S&P 500 Stocks During the 2020 Market Selloff (2020/02/01 - 2020/04/01)

A Roadmap for Building Wealth

In my opinion, the wealth-building journey should follow a logical path:

Eliminate Debt:
The compounding effect works both ways. Paying high interest is like compounding in reverse—it’s a powerful force, but it works against you.
Build an Emergency Fund:
Having 6–12 months of living expenses in cash provides stability and peace of mind.
Invest for Retirement:
Once financial stability is achieved, long-term investing through diversified portfolios makes sense to secure future needs.
Move Beyond Retirement Goals:
Once retirement goals are well on track, it no longer makes sense to stop there. At this point, it's time to consider strategies that aim for wealth creation, not just preservation. This is where speculative, high-return strategies can be incorporated—ideally using a clearly defined portion of one’s capital. The goal shifts from just retiring comfortably to building something significantly larger.

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