Risk versus volatility, is there a difference?
A few weeks ago on my blog after Three Steps to Plan Your Portfolio was published, there was a lively discussion about risk after I suggested investors should consider answering the following questions before diving into product selection for their portfolios:
- What is my current risk tolerance for investing? Risk, what are you talking about?
Some comments ensued and some folks suggested risk and volatility are one of the same.
I beg to differ.
Let’s take a look at some classical definitions:
(General) Risk – possibility of loss; something that creates or suggests a hazard; the chance of loss, the chance that an investment (as a stock or commodity) will lose value.
(Financial) Risk – chance an investment’s actual return will be different than expected; possibility losing some or all of the original investment.
“A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk.”
Financial risk usually manifests itself when assets are poorly balanced or not diversified. In the insurance business, you avoid risk by insuring against a catastrophic loss. For example, if you want to take on more financial risk that usually means more stocks and fewer bonds in your portfolio. Boring bonds provide safety and thus promise less growth. You can read an article about that on Canadian Couch Potato. Diversification is also a hedge against risk. Too few securities, in too few industries will increase your risk. You can lower your risks by investing in broad market Exchange Traded Funds (ETFs) across many markets. When it comes to insurance, many people choose to buy it to transfer the risk to someone else (for a fee).
Volatility – a statistical measure of the dispersion of returns for a given security or market index; price fluctuations over a defined time period. A common definition:
“In other words, volatility refers to the amount of uncertainty or risk about the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.”
As you can see, the terms risk and volatility are not interchangeable although they are related.
What is an investor to do, focus on risk or volatility, both?
I’ll speak for myself. As a long-term investor I’m not worried about volatility in my portfolio since price fluctuations will always occur. If your investment plan stretches 20 or 30 years, I’d argue you shouldn’t care about volatility either. Mr. Market will always try and trick you (or I) into selling or buying something at the wrong time.
Instead of worrying about volatility I will focus my energy on reducing risk across my portfolio through primarily good diversification and asset allocation. I will also reduce risk by owning life insurance to offset the debt and liabilities I have.
Thinking and acting long-term, I recall the KISS portfolio from the Elements of Investing. The authors of this book claim if you follow the KISS portfolio (Keep It Simple, Sweetheart) almost every investor will be successful. Here are a few KISS elements:
- Save early and regularly, for as long as possible.
- Set aside a cash reserve for when “stuff happens”.
- Make sure you are covered by insurance, especially life insurance.
- Diversification will reduce your anxiety.
- Ignore the short-term sound and fury of Mr. Market; the biggest mistakes investors make are letting emotions dominate.
- Use low-cost index funds.
- Focus on major investment categories; avoid “exotics”; most investors should focus on owning common stocks, bonds and real estate (via home ownership).
What are your thoughts when it comes to risk and volatility? Do you focus on risk? Do you care about volatility?
Do you have other definitions of risk or volatility to share?