The Difference Between Investment Risk and Volatility

IRIS.xyz  |

By Rob Isbitts for IRIS.xyz

First, let’s be clear: “Risk” is the possibility that you will need money but don’t have it. That could be due to a plunge in the value of your investment portfolio. Or, because your investments are not very liquid, which means you could not turn them into cash quickly and easily.

For instance, real estate is not very liquid. Neither are many insurance and annuity vehicles. Investments in a private business are not very liquid either. A portfolio of investments that trade on the stock market are liquid, because between 9:30AM and 4:00PM Eastern Standard Time, you can see what they are worth just by pulling up a stock quote.

RISK VERSUS VOLATILITY

Liquidity is one risk investors may need to grapple with. But just because your investments are liquid, that does not mean their values are stable. That’s where “Volatility” becomes a threat to your wealth. Just ask anyone who has lived through the Financial Crisis, Dot-Com Bubble, or 1987 Stock Market Crash. Heck, the S&P 500 stock index fell by over 15% in just 3 weeks last December (2018). In the world of financial planning and investing, there are many moving targets.

These risks are tough enough for younger investors. But they are even more challenging for those who are within 10 years of retirement, or already retired. After all, the next financial shakeup will occur very close to when you likely plan on using the wealth you have been accumulating for decades. This is not the time to “let it ride” and hope for the best.

The first chart below is what I consider to be volatility. The investment (in this case, the S&P 500 Index), shakes around a lot. That is, its value hops up and down, often returning to a place it had been in the past. There is no sustained up or down movement outside of that “trading range.” Also, a drop below the tightest part of the range (late 2018) turns out to be temporary. Like a super hero that comes in to save the day.

THIS IS VOLATILITY

The other chart (below) is what happens when volatility converts into risk. In other words, an investor who decides to “hang in there” and “be a long-term investor” does not get away with that approach. Instead, the value of the investment continues to drop, as in Dot-Com Bubble (March 2000 through March 2003). As a result, the loss is not very temporary and is sustained, to the tune of a 45% reduction from its peak.

THIS IS RISK

Think about that. You have $1,000,000 invested, and 3 years later it has “grown” into $550,000! This is what happened during the Dot-Com era, the Financial Crisis, and following other periods of financial excess. Now, we never know what will happen next. But we can take a proactive approach to investing in a way that acknowledges that these things can happen.

Related: Why All 60/40 Portfolios Are Not Created Equally

HOW NOT TO FREAK OUT ABOUT IT

So, what do you do to keep yourself from freaking out the next time things get rough? First, it helps to separate “risk” from “volatility.” They are not the same thing. Volatility in investing is often temporary, but it can spill over into risk if you don’t know yourself well enough as an investor.

That’s because volatility can get emotional. And once you let emotions into your investment and financial planning approach, it is like taking up drinking to try to stop yourself from smoking. It may only transfer the problem from one place to another. That’s not planning!

So, you must find a healthy balance. Over one shoulder, there is the volatility you know is inevitable in your financial life. Over the other shoulder, there is the risk of taking that volatility too lightly. You need to address head-on the potential for small losses to become big losses that can threaten your plans. Unfortunately, many traditional approaches to building an investment portfolio don’t really address this.

A WAY FORWARD

You need to establish some “guardrails” around whatever investment approach you take. That is, determine how much loss of value you can take before those emotions start to demonize an otherwise solid approach. This is like a cardiac stress test as preventive medicine against a potential heart attack.

Sidestepping the landmines of volatility and risk are an essential part of increasing your odds of success. That starts with going beyond the buzzwords. At the most basic level, distinguish between what is truly risk, and what is simply volatility. That is great first step toward reaching a real understanding about what matters to you.

My concern these days is that investors blow off volatility when it does not turn into real risk to them. In other words, they get overconfident. Retirees and those within a decade of retirement cannot afford to be so casual about that.

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DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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