The Difference Between Volatility & Risk

2015-04-02

Investment VOLATILITY can be defined as a statistical measure of the dispersion of returns for an investment over me. Investment RISK is the probability or likelihood of loss relative to the expected return of an investment.

To put things more simply, volatility is the potential for fluctuations in the price of an asset (investment) and risk is the potential for loss.

Volatility

Many people believe that the higher the volatility, the riskier the investment – however that’s not always the case. You can have an extremely strong blue chip company that experiences quite a bit of volatility (stock price fluctuation) however it may be an excellent addition for your portfolio. Compare that to a company with high levels of debt, low assets, high liabilities, and a poor performance record … yet their stock price hasn’t moved much in months or years (less volatility). Which would you buy?

Investment volatility is quite normal – asset prices go up and down on a regular basis. While this may cause sleepless nights for some investors, it’s viewed as a buying opportunity by others (one of the many ways the great Warren Buffett made his billions). For example, if you have $100,000 to invest, wouldn’t you rather buy assets at a lower price than at a higher one? Of course. Purchasing an asset when it’s value is under-rated makes good financial sense.

Wise investors (and advisors) perform due diligence before buying. That means investigating many factors including what levels the investment has historically traded at, a full technical analysis on the economics of the company (how healthy the balance sheet is, assets, liabilities, debt levels), how profitable the company’s been over a number of years (not just last month/year). Financials moving in the right direction for a number of years (growth vs decline stage) can indicate strong management and leadership, and a potential expanding marketplace (be sure to investigate or already be very familiar with the pros and cons of the product or service they offer). If the investment meets all purchasing criteria, they are poised and ready to buy when the cost declines below a pre-determined level. When that happens, purchasing power is increased because more of the asset can be bought for the same dollar value – and that makes good sense. Then, when markets are buoyed (or when whatever it was that caused the asset value to drop returns to normal, as it usually does) their $100,000 investment usually gets a good healthy bump. Of course there is never a guarantee that an asset or stock price will rise, however we can greatly improve our odds by paying very close attention to the markets, history, and the knowing how to identify strong, healthy investments.

Risk

The potential for loss can be mitigated in a number of ways. Again, performing due diligence on the investment/company is key. The careful selection of assets for your portfolio will greatly reduce most firm-specific risk (which is often referred to as non-systematic risk) leaving only market risk (systematic risk) to your portfolio. And since we can’t control the markets or other external factors, being extremely selective about which investments we purchase is key.
You can also reduce risk by geographically diversifying your portfolio (acquiring global assets). If your portfolio consisted of assets from only one country, and that country suffered a market meltdown, currency crisis, or similar, you can bet that your portfolio would take a pretty big hit. By diversifying globally, one country’s economic strife should not seriously impact your portfolio’s overall value.

Owning more than one type of asset (stocks, bonds, mutual funds, GICs, etc.) in your portfolio can also reduce risk. Various micro and macro factors (management, performance, competition, interest rates, central bank interventions, geopolitical issues, etc.) can impact particular assets in different ways, so diversification can reduce not only risk but volatility as well.

You can also hold assets in your portfolio that behave in opposite ways to each other. This is called negative correlation – a statistical measure of how two securities move in relation to each other (which is the idea behind hedging). Negative correlation means that when one asset decreases in value, the other rises. Even though there is fluctuation (volatility) in the value of each asset, the anticipated result is less overall volatility in the total value of your portfolio.

There are other ways to decrease risk and volatility in your portfolio, however I’ll leave you with a couple of key things to consider.

A decrease in the value of an asset is not necessarily a permanent loss. In the investing realm it’s commonly referred to as a ‘paper loss’. In other words, unless you plan to sell the asset while it’s down in value (before the market/asset can recover) it’s only a decline on paper. If you are holding carefully selected, great investments for the long term, they will usually recover when the markets do (or when/if the influence that caused the decline mitigates itself).

In conclusion, reduce risk in your portfolio and remain patient and calm when markets get rocky. One of the worst things you can do is panic and sell. Alter your mind-set to consider declines as potential buying opportunities and start benefitting from volatility instead of fearing it.