Volatility & Risk

Consider the roller coaster ride. I get in, the ride starts and I wait to get to the end. Some parts of the rides are slow, some are fast, some are scary and some are fun. Eventually, I get to the end. This could be called “Roller Coaster Volatility”.

Now, if I considered the risks with this ride, I would be looking at the risk of the roller coaster cable snapping, my seat belt breaking, emergency brakes failing…So is the up, down  path to the end of the ride and the risk of the ride failing the same thing?

Many investors identify risk as market volatility and mostly view volatility as a bad thing. Are they the same? The path to achieving income and growth goals through an investment portfolio are not the same as volatility of the market.

“Volatility is the relatively large and unpredictable movement of the equity market both above and below its permanent uptrend line.” Source: By Nick Murray.

For example, stocks can be up 10% 1 year and down 50% the next. Bonds on the other hand, maybe up 5% in 1 year and maybe down 1% the next. Bonds do not have as big movements as stocks (less volatility) and it has been proven that stocks outperform bonds over the long term. Investment industry uses various financial statistics to identify volatility such as Standard Deviation or Beta to measure volatility. Standard Deviation shows how much an investment’s return varies on average over time, beta is a measure of relative volatility showing the variance of the investment versus the overall market. Think of the roller coaster going up or down.

So what is risk? Specifically, what is an investor’s risk?

Risk was defined by someone as “means more things can happen than will happen”. Source: Reuters. Risk is uncertainty of not achieving your goals if there is a permanent loss either due to the market or more importantly your emotional reaction to the market movement (volatility). In a previous article, we wrote about different forms of risk, such as Risk Capacity, Perceived Risk and Required Risk. We spoke about making decisions about portfolio allocation considering all these elements of risk (your willingness and your ability to take risk) rather than recent market performance up or down (volatility).

Financial industry and media often mixes volatility and risk. Post financial crisis, the industry flooded the marketplace with low volatility products touting them as less risky products. As you make a decision to invest in such products, you may choose to consider the consequences of low volatility products, i.e. lower long term returns. Using the roller coaster example, a small kiddy roller coaster does not give as much pleasure as a 4th Dimensional Roller Coaster. Low volatility products inherently will have lower returns compared to the overall market.

Financial industry also portrays volatility as bad. Is it? In the last 35 years, the average intra year decline in the S&P 500 was in excess of 14%. The chart shows that while the market could have intra year declines ranging from -3% to -48%, its returns were positive 81% of the time in the last 25 years. Source: Nick Murray.

The point being that volatility could be high or low but volatility is not bad. Volatility could go up or down but by itself, it does not impact the long-term returns of an investor unless the investor reacts to the volatility. Risk and volatility are not interchangeable.

As you look to make a portfolio allocation change or a new investment, consider your risk preference and choose investments that match your risk and long term goals rather than solely considering an investments volatility. Rather than relying on the up and down of the investment to evaluate risk in your portfolio, it would be more rational and productive to consider your risk capacity, your emotional tolerance to risk and your perception of risk.

Don’t fear volatility! Mixing volatility and risk could make you react to the market which could make it a permanent loss as it could result in the long-term failure to meet a final outcome. A risky proposition!



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