The Critical Difference Between Volatility and Risk

The Critical Difference Between Volatility and Risk

Many investors confuse volatility and risk.  They are fundamentally different concepts.  Savvy investors need to understand why each is important.

Risk

“Risk” refers to the potential of an investment to lose all or a portion of its value. 

While risk is often expressed as the possibility of losing money,  it can also include the failure of investment to earn the return you expected when you bought it.

FINRA defines risk as “any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.”

According to the U.S. Securities and Exchange Commission (SEC), risk is the degree of uncertainty and potential financial loss resulting from an investment decision.

When the risk of loss is high, investors typically seek greater returns to compensate for assuming more risk.  

Every investment involves an assessment of risks and expected returns.  Investors need to consider the liquidity of their investment, how rapidly their investment is likely to increase in value and how secure their investment will be. 

There are a number of risks confronting investors.  Here are the most common ones:

Types of investment risk

1.  Business risk

When you purchase a stock, you buy an interest in the company that issued the stock.  When you purchase a bond, you loan money to a company or governmental entity.  Both investments require an assessment of risk.

A company could go bankrupt, leaving shareholders, who would be categorized as unsecured creditors, with little or nothing to recover in a bankruptcy proceeding.

When you loan money to a company or governmental entity, you are relying on the ability of the borrower to pay that money back.  If they default, you will be in a better position than owners of shares to recover your investment in bankruptcy, but you still can lose all or a portion of your investment.

2.  Interest rate risk

Changes in interest rates can impact the value of bonds if you need to sell your bond before maturity.  If interest rates go up, the value of your bond may go down because investors can secure a higher interest rate by purchasing a more recently issued bond.

If you need to sell your bond in a rising interest rate environment, you would likely incur a loss.

3.  Inflation risk

The long-term historical rate of inflation in the U.S. is 3.26%, although it’s currently much higher at 8.5%.

Inflation reduces purchasing power because the cost of goods you purchase is impacted by the inflation rate.

Investors who purchase fixed income bonds that pay less than the inflation rate will lose purchasing power over time.

4.  Liquidity risk

Liquidity risk refers to the risk you won’t be able to liquidate your investments when you want to do so.

If there’s no market for your shares, you may be stuck with them until market conditions change.

Some complex investments may require you to hold them for a stated period of time or charge you a penalty for early withdrawal or liquidation.

Mitigating risk

There are ways to mitigate risk, but it’s important to remember that the lower the risk, the less return you can expect to earn.

The Federal Deposit Insurance Corporation insures certain deposits up to a maximum of $250,000 per insured bank, but these investments currently pay a very low rate of interest.

Deposits in federally insured credit unions are insured up to a limit of $250,000 by The National Credit Union Administration.

You may qualify for reimbursement from the non-profit corporation SIPC if the brokerage firm holding your shares fails.  SIPIC does not protect against the loss in value of your shares.

Volatility

Volatility in investing refers to “the frequency and magnitude of price movements, up or down.”

The bigger the swings in an investment or market price, the more volatile it is.

Any investment in stocks or index funds (which track a benchmark index) involves volatility of varying degrees.  

Measuring volatility

It’s possible to measure volatility using a statistical measurement called “standard deviation.” 

The standard deviation calculates how much an investment’s returns can deviate from the average.  The more volatile the investment, the higher the standard deviation.

In more technical terms, the standard deviation is the square root of variance determined by calculating the deviation of each data point relative to the mean.

Coping with market volatility

When the stock market or the value of an individual holding of shares fluctuates widely, it creates uncertainty, leading to anxiety and even panic selling.

A competent registered investment advisor plans for market volatility by investing in a globally diversified portfolio in a suitable asset allocation.  Your RIA will provide perspective by explaining that significant market downturns historically have been relatively short compared to bull markets. 

Informed investors consider short-term market volatility as “noise” and stay focused on their long-term plans.

The relationship between volatility and risk

It’s important to understand the relationship between volatility and risk and not to assume that either are always bad for investors.

There are benefits to high volatility.  An investment can be very volatile but still increase meaningfully in value.

The stock market may be very volatile now, but that may present an opportunity for long-term investors to purchase stocks at a discount and hold them for higher expected returns.

Don’t conflate volatility with risk.  If you hold a volatile investment and are a short-term investor, the risk of that investment is much greater for you than for an investor who can wait out the market volatility.

Long-term investors should focus more on risk and less on volatility.  A well-informed, long-term investor is more likely to suffer losses from poor investment choices and a failure to diversify their portfolio than from short-term stock market volatility.

The commentary presented herein contains the opinions of Daner Wealth Management, LLC (“DWM”), a Securities and Exchange Commission Registered Investment Advisor.   This information should not be relied upon for tax purposes and is based on sources believed to be reliable.  No guarantee is made to the completeness or accuracy of this information.  DWM shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses, or opinions contained herein or their use, which do not constitute investment advice, are provided as of the date written, are provided solely for informational purposes, and therefore are not an offer to buy or sell a security.  Investments in securities are subject to investment risk, including possible loss of principal.  Prices of securities may fluctuate from time to time and may even become valueless.  This information has not been tailored to suit any individual. 

Don’t conflate volatility with risk. If you hold a volatile investment and are a short-term investor, the risk of that investment is much greater for you than for an investor who can wait out the market volatility.

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