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When it comes to the two more fearsome words in the investment world- volatility and risk- most wade around the two concepts without clear knowledge of either. In fact to most investors these two words are often used interchangeably. Failure to understand the difference can lead to mistakes that may endanger the future of your investments and put a dent in your profits (or eat them up entirely). So, while calibrating your investments and projected growth and developing strategies, it is important to understand how volatility and risk affect your returns.
Volatility is often defined as a statistical measure that predicts the dispersion of returns for a given security and market index. It is estimated by standard deviation or variance between returns from same security. A common relation between volatility and risk is that higher the volatility, riskier the security. However, in reality, the relation is more complicated and not so linearly related. So basically, it is the amount of uncertainty about the magnitude of changes in the security value: low volatility means less dramatic fluctuation in the security’s value. A measure of volatility of a certain stock relative to the market is called beta, which is the approximation of the total volatility of the security returns against an appropriate benchmark. For instance, if a stock has beta value of 1.1, it has moved 110% for 100% movement in the benchmark.
Risk is one of the most misused terms in finance; it is the chance of actual return from an investment being less than the expected return. So risk involves the possibility of losing part or whole of your investment. Risk is measured as variance or standard deviation of the average returns of an investment; a high deviation implies high risk. A lot of investors allocate money after developing risk management strategies. These strategies are developed after detailed risk assessment. The idea of balancing risk and return is one of the most discussed topics of the financial world. Greater the risk an investor is willing to take, higher the possibility of significant return. Naturally, investing in the safe investments, like treasury bonds, will generate much lower return than corporate bonds which are generally high risk.
The relation between risk and time is inherent, but omitting the time factor in assessing risk is a common mistake committed by investors. The thing with calculation of risk is that it is based mostly on probability. Let’s suppose you throw a dice and a six will win you $10 and if not, you will lose $1. Although the loss is more likely (5/6th chance), the win will fetch you more than a loss takes away from you. But this route of reasoning is more applicable to average different outcomes than average through time and as physicist Ole Peters of London Mathematical Laboratory says, the two aren’t the same. So, if you give it a number of tries, rough calculation of the dice trick will show average of about 83 per cent. So the more you play, the more you can potentially win.
An investment vehicle’s volatility is constant; for instance, stocks are considered to be volatile. It will be volatile over a 1 year period, 5 year period, 20 year period or 50 year period. Time is immaterial and on a plot against time it never moves up in a straight line. So, it is actually risk that determines which investment option is ideal for you, not volatility. Let us consider that you have a sum of money you want to invest over the next two years. It is a short period of time; the stock market, being more volatile, is not the ideal place to put your money into. Now let us suppose you want to invest to save up for your retirement twenty years later, which is a decidedly long period of time. In this case, stocks would be a good option. So, despite being a volatile investment vehicle, it is not risky anymore.
In order to make sure your investment doesn’t suffer the sorry fate of being either low risk with guarantee of low return or high risk with possibility of high return. On one hand, your investment needs to grow in order to stay one step ahead of inflation that tends to reduce the real value of your assets. On the other hand, taking on more risk that you can afford is not a wise decision either. So it is very important to strike a balance between the two. The Portfolio Theory proclaims that more volatile assets are riskier; therefore higher return can be anticipated. However, any sound investor observing the Australian market would be able to point out that the theory is not gospel. Mining shares have been more volatile throughout the twentieth century, but the returns were significantly lower than corporate and industrial shares.
Both volatility and risk are important parameters that limit the returns of your investment. But since they are different, which do you concentrate on more? If you are a long term investor, you can afford to not focus on volatility. So the concentration should be more on reducing the risk involved in the investments. This can be done by saving early and regularly for long term, as long as possible. It is also important to set aside some buffer cash or asset, in case things go downhill. Insurance cover, especially life insurance, is also important. Apart from that, using low cost index funds, choosing major investment categories instead of exotic ones and avoiding short term investments completely are good measures of reducing risk.
Risk is one of those capricious parameters that can catch you off guard any moment, and in a moment’s interval, sweep you off your feet. Again, a particular investment can get sudden boost all of a sudden. For example, if there is a natural calamity in a particular locality, the hotels’ profits will plunge, but the contractors responsible for rebuilding the area will get an unexpected boost in pay checks. So, it is up to the investor to stay prepared for the unexpected.
Risk tolerance is the investors’ willingness to lose their original investment partly or wholly to get higher return in the long run. Investors are naturally risk-averse. That means the pleasure one gets from certain return is much less than loss of the same amount. So, most investors opt for investments with low fluctuation, i.e., low volatility, and less susceptible to huge losses. But those with an extended time horizon (the period of time through which you intend to invest your money) opt for investments of high volatility, like stocks, which potentially generate high returns.
While the assumption that there is no possibility of significant gain without risk is generally true, there are risks that offer little potential return. So it is crucial to indulge in risks that are absolutely necessary to induce portfolio growth and not risk any further. On the other hand, volatility is not something you can do away with, but mitigate with lengthening your time horizon and following some measures. Risk is time dependent, volatility is not. Using this distinction, both the vagaries of the financial world can be managed.
