Demystifying investment speak – what is the difference between risk and volatility?
We like to cut through the complexity of jargon that exists in the investment world and explain things so that everyone can understand. You shouldn’t have to be a finance professional to understand financial and market analysis.
In this article, we are focusing on speaking clearly about risk versus volatility in investments. This topic is timely as markets move around from week to week, especially if you are looking at your investments and seeing them go down in value lately.
Let’s start with what these terms mean. They are often used interchangeably but in reality, mean different things, which can change the way you look at an investment.
What is risk?
In this article, we define risk as the potential to lose an asset absolutely. This means, for example, you might buy a share in a company for €100. If that company goes bust, your shares are not worth anything, and you have lost the €100. This is risk. We saw this with some of the more speculative cryptocurrencies in recent years.
There are many types and sources of risk beyond the risk of absolute loss as we have described above.
Here are a few more examples:
• Currency risk, where the exchange rate between currencies may move adversely against you. this may be when you are moving money between currencies or in your investments.
• Inflation risk is the risk that you are invested in a low-risk investment such as in cash and that your return is less than the rate of inflation meaning you are losing money by the difference in the return achieved and the rate of inflation.
• Liquidity risk is the risk that you cannot sell your investment when you wish or at the price you wish. This risk is reduced with diversified and collective investments however as markets can go up or down you need to be aware of this risk.
• Concentration risk is the risk of having all your investments in one particular investment or type of investment. A diversified portfolio can reduce this risk if the assets are not highly positively correlated. This means that do not act in the same way as market movements.
• Reinvestment risk is the risk that on maturity of an investment you are required to reinvest at a lower rate of interest.
• Credit risk refers to investing in bonds, either corporate or government. It is the risk that the bond issuer (the company or the government) cannot return your capital.
Being aware of the risk of an investment is very important and protecting against this potential loss is part of good financial planning.
What is volatility?
When we talk about volatility, when you hear about it reported in the news and spoken about on podcasts and on the radio, many people actually use the phrase market risk, when they mean volatility, which is why it becomes confusing. If risk is the potential to lose your asset absolutely and permanently, as we described above, volatility describes how the value of an investment, or a market, changes from one day to the next.
Volatility, by this definition, is not as scary as risk. It is also much more normal in investments. The volatility of investments and markets can be in both directions, up and down. There is even an index that captures volatility (and for the high-risk professional investors, can be traded on) called the VIX, or volatility index. It captures how much the price of a market moves from one day to the next.
There is one way you can convert volatility to risk and that is by selling an asset when its value falls. If you do that you crystallise a loss, which is a risk realised.
We have said that volatility is movement, both up and down, and it is normal in an investment. The next piece of the puzzle is linking this to the other market factors, and patterns of behaviour.
The first is market growth. We know that markets go up over time. This applies to stock markets and economies and is why a loaf of bread costs more than it did when you were a child. Expanding on this to say that markets go up over time with volatility, we get the understanding that markets go up over time, but not in a straight line. We can see this if we look at a graph of the US stock market over the last 50 years.
We can see there is volatility, but that volatility reduces over time. In fact, try and find the 1987 crash on the graph and now it looks like a small blip.
With these definitions in mind, when you look at your investment and see that it has gone down in value, an important consideration is to see if you can separate risk from volatility.
Some more jargon to bust:
When markets go up for a prolonged period, they are said to be Bull markets, and when they fall, they are called Bear markets. It is just finance speak for up and down. The graph from JP Morgan below shows that we have cycles of bulls and bears, or up and down markets, and that the up markets are stronger and longer than the down markets, hence markets going up over time.
Finally, when looking at your investments and assessing for risk and market volatility, the major factor that reduces volatility is time. Consider the table from JP Morgan below. If you look at the grey bars- they represent stock markets and are called ‘large-cap equities’ here – it shows there is a potential downside risk in one year of 43%. Over ten years this reduces to -3% and over 20 years it disappears altogether. Time can reduce volatility and the risk of loss.
Volatile markets can be upsetting so it’s good to be mindful of the difference between the risk of absolute loss and temporary price movements. If you would like more support, information or an assessment of your situation, please reach out to the team at Extended Investments Limited at info@extinvestments.com and we will be pleased to speak with you.
