The terms "risk" and "volatility" are sometimes used interchangeably, however they do not mean the same thing. The two are occasionally related, but recognizing the distinction between risk and volatility is critical for investors making sound decisions. Understanding how risk affects specific investable assets can help you better match your investment portfolio to your investment goals, whereas understanding volatility can help you better match your portfolio to your risk tolerance (conservative, aggressive, or moderate), especially when it comes to weathering market downturns. Here, we'll look at how risk and volatility differ in some ways but overlap in others.
In recent years, the investment landscape has undergone significant changes, with the rise of digital assets and the increasing influence of global events on financial markets. These developments have added new layers of complexity to the concepts of risk and volatility. For instance, the COVID-19 pandemic demonstrated how unforeseen global events can dramatically impact markets, causing unprecedented levels of volatility across various asset classes. Similarly, the emergence of cryptocurrencies has introduced a new dimension of risk and volatility, challenging traditional investment paradigms and forcing investors to reassess their strategies.
In the investment sector, "risk" often refers to the likelihood that an investment would underperform its projected value. In many circumstances, this is monetary loss, but it may also be situational losses or failure to achieve a desired goal, such as liquidity risk, which indicates that it is difficult to convert your investments into cash fast, potentially causing you to miss out on other buying chances. All investments involve some level of risk. Even fixed annuities, which have a guaranteed rate of return, have the potential to fail, for example, if the insurance firm backing the annuity goes out of business, or if some other backstops fail to function properly.
However, some investable assets that are usually thought to be low-risk include:
- Series I Savings Bonds
- Treasury Bills, Bonds, and Notes
- Highly rated corporate bonds
- Certificates of deposit (CDs), especially short-term CDs
Fixed Annuities
Money Market Funds
These are sometimes regarded as low-risk because there is little chance of losing the money you invest, but this generally comes at a cost, as risk and return are associated. This is also known as the risk-return tradeoff, which states that the bigger the risk, the greater the likelihood of a high return. The lesser the risk, the lower the probability of a good return.
The concept of risk in investing has evolved significantly in recent years, particularly with the advent of sophisticated risk management tools and techniques. Modern portfolio theory, for instance, has revolutionized how investors approach risk, emphasizing the importance of diversification and asset allocation. Additionally, the development of financial derivatives has provided investors with new ways to hedge against various types of risk. However, these innovations have also introduced new complexities and potential pitfalls, as evidenced by the 2008 financial crisis, which highlighted the dangers of over-reliance on complex financial instruments and models.
Although riskier investing opportunities may be appealing, only those who can withstand significant financial losses should invest in high-risk assets. High-risk investments typically include:
- Individual stocks.
- Hedge Funds
- Private Equity Funds
- Cryptocurrencies
- Real estate investments, including REITs.
The level of risk can still differ across various investments, for example, certain well-established companies may be perceived to be less risky than those that have recently gone public. Individual stocks are risky since you are placing all of your eggs in one basket, which most stock traders and financial advisers advise against, especially if you are a beginner. Beginner investors are usually better off diversifying their portfolios with a variety of assets from several market sectors. Diversifying your investing portfolio reduces risk to any one asset while increasing market exposure. Holding a varied variety of assets can also help with volatility because it balances out the ups and downs of investment.
"Through intelligent portfolio building and diversification, investors can create a portfolio of risky assets with aggregate volatility that is lower than any of the individual securities," says Nathan Wallace, Grey Fox Investors' founder and head of investment management. "The key here is to buy securities with the goal that when one asset is performing poorly, another asset will pick up the slack through positive performance."
Your time horizon influences whether investing in a riskier venture is a wise decision. Younger investors are better suited to high-risk investments since they have more time to recover from potential losses. The reverse is true: elderly investors approaching retirement age do not have time on their side and are generally better off with low-risk, low-volatility investments.
The role of technology in shaping investment risk and decision-making cannot be overstated. The rise of robo-advisors and algorithmic trading has democratized access to sophisticated investment strategies, allowing even novice investors to build diversified portfolios tailored to their risk tolerance. However, this technological revolution has also introduced new forms of risk, such as cybersecurity threats and the potential for flash crashes caused by high-frequency trading algorithms. As a result, investors must now consider not only traditional market risks but also the technological risks associated with modern investment platforms and strategies.
Types of Risk
When determining the potential of losses or opportunity costs, investors should examine a wide range of risk factors. Some common ones are:
Market risk: Investment risks are classified into two types: systemic and unsystematic risk. Market risk is systemic risk, which refers to the likelihood that an investment will lose value due to market performance, regardless of the asset's underlying fundamentals. For example, a firm's stock may be performing well, but there is a danger that investor fears of a recession may create a stock selloff, causing the stock of that highly profitable company to fall as well.
Unsystematic risk (also known as specific risk) is the probability that an investment will lose value due to the performance of a certain industry or business.
Credit risk refers to the possibility that a borrower would be unable to satisfy its loan commitments, resulting in default. Investing in corporate bonds from companies with a high credit risk, for example, increases the likelihood that you may not receive your money back since the company may be unable to pay bondholders.
Liquidity risk is a systematic risk related with how easily you may convert your investment into cash. Illiquid assets, such as real estate and cryptocurrency, carry a higher liquidity risk. If you are unable to sell an item when you desire, you may miss out on an unexpected opportunity or incur charges, such as having to charge expenses to your credit card if you are short on funds.
When you invest in assets from a foreign country, you take on exchange-rate risk, often known as currency risk. If the value of the foreign currency fluctuates, it may lose value. For example, if you invest in stock in France and the euro falls in value relative to the US dollar, you may lose money even if your stock increases in value. That's because when you sell the stock and convert the euro to the dollar, the lower the euro value, the fewer dollars you receive.
Commodity risk: The value of a commodity investment may decrease if the underlying physical good becomes less valuable. Commodities, such as agricultural products, are influenced by uncontrollable factors such as weather or other natural calamities, and therefore can pose significant, unanticipated risks. The finest commodity trading applications include a variety of investable tangible goods, such as soft commodities, precious metals, and cryptocurrency.
Country risk: A systemic risk caused by the financial and economic soundness of the country that will distribute your investment. This risk affects assets related to a country's financial well-being, such as equities, bonds, futures, and so on.
Business risk is the risk associated with a company's success, which is determined by whether it is profitable and generates enough money to pay operating expenses such as office rent, administration fees, staff salaries, etc.
Operational risk: A type of business risk that is related with daily business operations, such as human errors, the possibility of fraudulent behavior, or problems caused by internal processing breakdowns.
Interest rate risk: A systematic risk that is a subset of market risk and is related with the value of an investment based on the economy's interest rate. Interest rate risk is more likely to directly damage bondholders than stockholders, as rising interest rates can cause bond prices to fall.
Inflation risk: A systematic risk that is also a subcategory of market risk, causing prices to rise across the board. If inflation rises significantly, assets such as fixed-rate bonds may lose purchasing power and value.
Environmental, Social, and Governance (ESG) risk has emerged as a crucial consideration for investors in recent years. This type of risk assesses how a company's environmental impact, social responsibility, and governance practices may affect its long-term financial performance and sustainability. As climate change concerns and social issues gain prominence, investors are increasingly factoring ESG risks into their investment decisions. Companies with poor ESG practices may face reputational damage, regulatory penalties, or loss of market share, potentially impacting their stock prices and overall financial performance. Consequently, many investors now view ESG risk assessment as an integral part of their overall risk management strategy.
What is Volatility?
Volatility refers to how much the price or value of a specific asset or market sector swings over time. In a nutshell, it measures how frequently and how significantly the price or value fluctuates. Geopolitical events, market attitudes, liquidity worries, news stories, and natural calamities are all potential sources of increased volatility.
Volatility is not necessarily a bad thing. Large price swings may be unnerving for some investors, but if the long-term trend remains positive, it doesn't matter how much volatility exists. On a more technical level, high volatility has the ability to affect issues such as dividend and capital gains returns, but it does not have to have a significant impact on individuals who buy and hold stocks.
Consider how in a football game, it doesn't matter if your team leads by a touchdown, then falls behind by two scores before rallying and winning in the end. The score is volatile, but the eventual result is what matters.
Like risk, all investable assets are volatile or have the potential to be volatile. However, certain investable assets offer greater market stability than others.
Low-volatility investments typically include:
- Highly rated corporate and municipal bonds.
- Treasury bonds, bills, and notes.
- CDs
- Gold and silver are commodities.
In most circumstances, long-term investors do not need to be concerned about market volatility because the price of the investment will eventually even out – and ideally rise — with time. Short-term investors, on the other hand, are particularly exposed to high volatility.
High-volatility investments typically include:
- Cryptocurrencies
- Exotic currency pairs.
- Energy commodities
- Agricultural commodities.
The cryptocurrency market is recognized as one of the most volatile markets, as decentralized digital currencies such as bitcoin, ether, and dogecoin are easily influenced by investors' general perception of the coin or token. As a result, the value of cryptocurrency assets fluctuates continuously.
Other assets, such as stocks, might exhibit variable levels of volatility. Although the stock market is normally more volatile than bonds, some equities may be more stable than others.
Measuring Volatility
There are two major ways to look at volatility.
Historical volatility: This measure of volatility is based on an asset's prior price trends over a specific time period. As the name implies, it is background-looking and may not be a strong forecast of an asset's volatility in the future.
Implied volatility, also known as projected volatility, is used to forecast how much a specific investment will move over a given length of time in the future. Implied volatility is frequently assessed using options pricing, which provide insight into the price fluctuations investors believe an asset is likely to make. In general, bullish markets will have lower implied volatility.
Digging deeper, there are common metrics used to calculate historical or implied volatility, for example:
Beta: The volatility of a single investment or market sector in comparison to an underlying benchmark or overall market performance. According to Wallace, "A beta of 1 means that when security A goes up 1%, security B will [be expected to] go up 1%, while a beta of 1.5 means that when security A goes up 10%, security B would be expected to rise by 15%." In other words, an asset with a beta greater than 1 can be expected to have above-average volatility.
Standard deviation is a measure of historical volatility that takes into account how much an investment deviates from its average yearly rate of return. Volatility increases with bigger standard deviations. So, while an asset may have a high average annual return of, say, 10%, a large standard deviation may mean that you receive a 20% return in some years and 0% in others, rather than continually sticking around 10%.
If you're not a math whiz, don't bother about computing these measurements; most risk metrics are already disclosed by professional research organizations and some financial institutions.
Relationship to Risk
Volatility and risk are not interchangeable, but they are related. A high-risk investment is typically highly volatile, with significant up and down movements. However, high volatility does not automatically signify significant risk, especially over the long run. Stocks, for example, are frequently volatile in the short term, but over time, diversified stock investing is widely regarded as a relatively secure approach to invest for long-term goals such as retirement.
If you can handle extreme volatility, you may be rewarded in the end. However, there is a risk that high volatility will drive investors to make irrational decisions. For example, if you observe stocks tumbling rapidly, you may become afraid and sell your investments, locking in losses. Instead, if you could have waited out the volatility, you might have seen asset prices rebound.
Furthermore, volatility might cause specific sorts of risk in certain scenarios. For example, a retiree with a highly volatile portfolio may experience liquidity risk in the sense that they may be hesitant to sell assets during high volatility times when prices are low, as this would lock in losses. However, if they are unable to sell during that downturn, they may encounter cash flow issues. That is why retirees' risk management strategies frequently include low-volatility assets.
Key distinctions between risk and volatility.
Risk and volatility are commonly synonymous, but there are some important distinctions. Specifically, there are some discrepancies regarding:
Timing
Risk can be both a short-term and long-term issue, depending on the type of risk, whereas volatility focuses on short-term changes.
Permanence
Risk is typically associated with the possibility of lasting losses, whereas volatility refers to short-term price movements that are not necessarily permanent. A volatile asset may be down significantly one day but rebound the next, but credit risk may imply that the asset never recovers owing to an issue such as bankruptcy.
Control
While both risk and volatility frequently include elements beyond an investor's control, risk is commonly viewed as a more internal issue inside a portfolio that an investor can control, whilst volatility is something that is more likely to occur. For example, an investor could build a diversified portfolio that reduces market risk by including assets that move in uncorrelated directions. However, volatility is not always as straightforward to manage, as much depends on the short-term behavior of other market participants.
How to Assess and Manage Risk
There are numerous approaches to risk assessment and management, especially when developing an overall investment portfolio. This requires emphasis on:
Diversification
Portfolio diversification is a typical strategy for reducing risk exposure. Holding both stocks and bonds, for example, can reduce market risk because if investors begin to shift away from stocks and toward bonds, stock prices may fall while bond prices rise, so having both can help balance your portfolio. Furthermore, maintaining a diverse portfolio of stocks can assist mitigate other types of risk, such as balancing nation risk by owning equities in both the United States and other countries.
"Investors can gain diversification by investing across regions, asset classes, sectors, and even exposure factors," according to Wallace. He describes how beginners might begin diversifying their portfolios by "taking the time to learn about the different correlations as the first step in your investment journey."
Asset Allocation
Asset allocation is related to diversification in that it refers to how you divide your investments among various asset categories. As previously stated, allocating to both stocks and bonds may reduce risk, and you can also invest in other assets such as commodities, real estate, collectibles, and others to balance your portfolio in a way that meets your risk tolerance while taking into account your investing objectives. If you are confused about the optimum asset allocation for you, consult with a financial professional.
Due Diligence
Doing your due diligence entails extensively researching investments before committing money to them. For example, if you're investing in mutual funds, you don't want to just pick one at random; instead, you should check the fund's prospectus and read reviews/ratings to determine if the fund's risk management and investment objectives match what you're looking for.
Long-Term Perspective
In general, taking a long-term view reduces risk more than short-term investing. For example, stock values might fluctuate drastically day after day. Some days, the market may fall by 2%, while others it may gain by 2%. If you pick the wrong days, you could face significant loses. However, if you focus on the long term, you may be able to benefit from long-term profits, as the S&P 500 has historically averaged roughly 10% every year.
How to Manage Volatility
Although volatility is typically regarded as unavoidable, albeit to varied degrees depending on the investment, there are still techniques to reduce or at least make it more manageable. This includes:
Dollar Cost Averaging
You never know when markets will rise or fall, but dollar-cost averaging can help you mitigate the effects of volatility. This entails contributing consistently over time, such as $100 every paycheck into your 401(k). That way, if volatility occurs and your assets begin to fall in value, you can buy in at a cheaper price point, lowering your average purchase price and perhaps increasing returns. This helps to balance out the occasions when you buy assets during upswings.
Rebalancing
Periodic rebalancing your portfolio, such as once a year, can help mitigate the impact of volatility by allowing you to return to your target asset allocation rather than being thrown off course. For example, if you invest 60% in stocks and 40% in bonds, but bond prices rise dramatically while stock prices fall, your portfolio value may change to 45% bonds and 55% stocks. Rebalancing is selling some bonds and purchasing some equities to return to a 60/40 split. You're also conducting some dollar-cost averaging; even if stock volatility has reduced their worth in your portfolio, you're buying back in at a lower price point and may benefit if they rebound.
Some investing platforms and financial advisors that specialize in portfolio management can automatically rebalance investments for you.
Staying Patient and Informed
Taking a long-term, patient approach can help you control risk and volatility by avoiding panic selling in response to short-term movements. Instead, being patient and informing yourself on what's going on in the market and why volatility may be temporary can help you avoid the unpleasant parts of volatility while also putting you in a position to benefit from any future gains. Remember that even assets with a history of increasing in value frequently experience down periods, which are usually transitory.
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