Understanding the Difference Between Risk and Volatility

Let’s clear up the confusion between risk and volatility when investing. Risks are real and consistently evolving.  This requires an investor to periodically re-assess their exposure and comfort level.  Examples include liquidity risk which is failing to set aside adequate cash reserves before it’s necessary.  The inability of your investments to keep pace with rising costs is purchasing risk.  Overspending (and underspending) relative to available resources is also a risk.

Volatility on the other hand is the up/down movement of prices on a particular investment.  All investments carry some level of volatility.  Fixed income and various bonds tend to carry less volatility than equities.  Why?  Lower expected returns with fixed income tend to be associated with smaller movements in price.

Less zigging and zagging in prices should mean lower volatility, but not always.  Investors may accept more up/down price movement with the assumption, never a guarantee, of larger potential returns.  That’s what diverse equities offer an investor.  If they can hang in there and stomach the volatility.

Volatility isn’t just a one-way street.  Slowly or rapidly increasing prices defines volatility just as it does for shrinking prices.  Our brain is formatted to view volatility only as a negative occurrence.  The reality is increasing prices are an example of volatility just as decreasing prices are.  Investors cheer increases as company values expand, but it’s important to recognize volatility works both ways.

The key take away is this, risk is not volatility and volatility is not risk.  So how do you manage both?

Accepting the truth in their differences and incorporating this knowledge into a financial plan is a start.  An investor’s perspective shifts as risks can be viewed differently than the up/down prices of various companies.  No longer is this a surprise or should it be surprising as values contract and expand routinely.  What happens this week or next year matters less when you are strategizing for the next thirty years.  Economic news and current events don’t need to carry the importance of influencing where, when, and how you invest.

Investors should consider these three questions:

• What’s actively being saved to cash, both for opportunities and room for error?
• What’s spent on essential expenses and fun?
• With the remaining dollars, what’s invested where?

The great thing about these questions is that each investor has their own unique answers.  It’s easier to answer all three questions together in the context of a financial plan.  This provides direction on investing and saving the right dollars in the right account while remaining flexible.  An investor’s wants will help define priorities as a timeline becomes clearer.

A financial plan based on monetary and life goals will help determine the appropriate amount of risk and volatility to expect.  The key is reviewing your approach annually and not being scared out of your selected investments prematurely.  Remember, investments do best when they are left to compound uninterrupted.

When investors understand the difference between volatility and risk, they may apply this knowledge to better behavior and less reacting along the way.

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