Risk vs. Volatility
This week as your friendly neighborhood CERTIFIED FINANCIAL PLANNER™, we're going to be continuing a series that we've been developing lately. This series has been looking into different risks surrounding investing and thus far has grown into a great way to grasp some of the basics about the subject. If you're interested in getting "caught up," please feel free to read What are Risks in Investing. In that post, we discussed a basic overview of risk when it comes to investing. We also discussed two basic categories that risk can fall into, systematic and non-systematic. Lastly, we discussed different specific forms of risk like equity risk, interest rate risk, inflation risk, credit risk, etc.
As a financial planner and coach, it's never my goal to scare anyone out of investing their money and creating a better future for themselves and their families. However, it is my job to educate my clients and potential clients about the dangers of the water they enter. Openly discussing risk is, in my opinion, a fantastic way to accomplish two goals. Firstly, it encourages those interested in investing to educate themselves and further look into these subjects. Secondly, knowing what to do or not to do is half of the battle with something like risk. By simply being aware of some forms of risk, you're ensuring that you will make better and more informed decisions moving forward.
However, as we've discussed in past posts, there's no way to eliminate risk in investing. While you can make educated decisions to carefully navigate and avoid unnecessary risk, there's no way to ultimately eliminate it from any financial plan – especially with investing. Also, as we've discussed, not all risk is terrible. Often the more risk you assume, the higher the rewards can be if things go according to plan; however, that is a discussion of risk tolerance that's important to have one-on-one with your financial planner or financial coach.
Today, we will discuss the differences, similarities, and confusion surrounding risk and volatility. These often conflated terms can stump investors at the beginning of the investing process. However, knowing the differences and similarities between the two will act as a fantastic way for you to distinguish between them.
What is Risk?
Let's start by reiterating some of what we already know from previous posts by refreshing our understanding of risk. Investopedia defines risk as "the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment." In other words, risk is the chance you won't recoup your initial investment, this can result from inside or outside influence. This is essentially what most people would think of if you were to ask them to outline what risk is.
As mentioned, some risks can be internal, and some risks can be external. Concentration risk is an excellent example of how some risks could be internal. This is the risk that you aren't diversifying your investments enough. For example, say you invest everything you own into the automobile industry, and something unexpected (like a microchip shortage) happens. At least in the short term, this causes your investment's value to plummet.
External risk can be broadly explained through systematic risk. This is also referred to as market risk and is essentially built into the fabric of our investing system (thus being systematic). For example, because of the nature of systematic risk, if the economy collapses or industry goes kaput, your investment becomes worthless or worth much less than it was initially.
Another notable characteristic of investing is that risk is often comprised in multiples. When there is risk, it's usually multiple kinds of risk, not just one pinpointed type of risk. There are multiple types, even in the first example given here about internal risk. While concentration risk is a substantial internal factor, there is also a systematic risk because the industry as a whole is suffering from a microchip shortage that was unforeseen before cryptocurrency mining, the pandemic, and supply chain issues compounded.
What is Volatility?
Volatility is much easier to understand, in my opinion than risk. According to Forbes, "volatility is the frequency and magnitude of price movements, up or down. The bigger and more frequent the price swings, the more volatile the market is said to be." Of course, this is the definition of market volatility; however, the same principles can easily be applied to individual investments.
Taking individual investment volatility into account is incredibly important when researching for your financial plan. In fact, something we mentioned earlier in this post is an excellent example of an investment with high volatility. Cryptocurrency – one of the newest trends among many investors is very volatile. The price of Bitcoin, the most popular cryptocurrency, varies wildly from day to day and can shift with as little as a tweet from a famous celebrity.
On the other side of the spectrum, an investment into a United States Treasury Bond or a tried-and-true company like Microsoft or Proctor & Gamble would be considered much less volatile. These are investments that historically perform predictably with a reasonably accurate prediction of returns.
How Risk and Volatility Relate and Work Together
You're probably starting to get a good idea of what risk and volatility are individually. However, it's often in a discussion where the two are intertwined, conflated, and confused. The reason for this is simple – they're tied to one another.
While risk and volatility are two distinctly different terms, the fact remains that they go together like peanut butter and jelly. The more volatile an investment is, the riskier it is and vice versa. Because a volatile asset fluctuating wildly in performance can cause you to gain or lose (on paper) a lot of money in a short period, it is also risky.
While risk and volatility are intertwined, it is crucial to remember that they aren't the same thing and that high volatility does not always equal high risk (and vice versa). An example of how something can be volatile but not necessarily risky can be seen daily. If the price fluctuates a lot, but the overall trend of an investment's value is positive, it can be argued that the investment is high volatility and low risk. The opposite is also true that an investment can have a fairly steady price while the company is in its end-of-life cycle, meaning an investment is low volatility and high risk.
Why are Risk and Volatility Often Confused?
The truth is that volatility and risk are often confused because people just seem to mix them up. Volatility often means high risk, and increased risk can often also mean high volatility. That, in addition to the fact that not everyone is a financial planner, or professional investor, leads to this confusion. However, the fact remains (as I've said a few different times already) that volatility and risk are two distinctly different things. To recap – risk is the chance that an investment will not go as planned, thus not bringing in the hoped-for market gains, while volatility is the fluctuation of an investment's (or the market's) price.
The more you know about the subject of risk and volatility, the less likely you are to fall into their traps! Of course, the best way to learn and distinguish between some of these financial terms is by getting to know your financial advisor. So if you'd like to redefine your relationship with risk and volatility to make them work for you, please, feel free to call or email to schedule an appointment with me. Together, we can create a financial plan that keeps your risk profile in mind and align your investments with your financial needs and goals.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.