By Judy Hulsey
When the market is performing well and volatility is low, it’s easy to be lulled into a false sense of security. As a result, investors tend to put more risk on the table. But as Nassim Taleb, author of The Black Swan and Antifragile, so wisely points out with the saying - “Never think that lack of variability is stability; don’t confuse lack of volatility with stability, ever" - a lack of variability in the market isn’t the same as stability.
Towards the end of the stock market cycle, there’s no reason to feel comfortable gambling. In these moments, understanding the concepts of risk and volatility becomes increasingly important.
Since risk and volatility never disappear, a good understanding of these concepts brings awareness to our emotions around investing and whether those emotions are worthy of affecting our strategy.
Risk and Volatility Defined
A common misconception is that volatility is risk. Although it’s understandable as to why someone would think this, the assumption isn’t accurate.
Risk is defined as "the possibility of loss or injury" by the Merriam-Webster Dictionary and volatility as “a tendency to change quickly and unpredictably.”
Risk refers to the possibility of loss, which is outcome focused. Volatility refers to a quick, unpredictable change, which isn’t centered on the outcome. To be a good investor, a person must be able to differentiate between these. Volatility acts as noise, while risk is worth paying attention to.
How Risk Is Measured
One of the easiest examples of the difference between risk and volatility can be found when we look at bonds. For those that are predominately familiar with stocks, a bond is really just a type of loan. When an investor buys a bond, he or she is giving someone a loan.
In a bond, there are many risks. Taking a very high-level view of bonds, let’s purely focus on whether the loan will be paid back or not (i.e. credit risk).
Whenever someone buys a bond, their original investment is called the principle, and there’s always a risk of losing part or all of the principle. Interest payments are the compensation provided for the risk of the loan as that loan matures (this assumes that you are not holding a zero-coupon bond). The main concern of an investor that buys and holds on to the bond until the loan matures (all else being equal) is whether the investor receives all of their principle and interest payments. There are many other concerns besides default that a bond holder may have, which are excluded for simplicity.
As a result, bond investors calculate the probability of default and the potential loss in the event of default. This is called expected loss. They want to quantify the possibility of losing money, in order to help make sound financial investments. This aligns with the Merriam-Webster definition of risk, and it’s how we measure the most basic level of risk associated with a bond.
The example above assumes that you are not lending to the U.S. government. U.S. Treasuries are considered a product with the least risk as historically they have only defaulted once on their bonds. However, as history is no guarantee of future performance one must consider that there could be risk associated even with U.S. Treasuries.
How Volatility Is Measured
Let’s use the bond example again. Even though “expected loss” captures the most basic risk associated with a bond in a measurable way, this isn’t how we would determine volatility.
Within investments, volatility is considered the variation from the average price. The most frequently used measure of volatility is called standard deviation. Standard deviation takes the variation from the average and standardizes it into units that are comparable. (The use of variation from the average is used as an alternative for variance in this article for simplicity. Variance is the sum of the squared deviations from the mean divided by the sample minus one.)
A bond’s standard deviation in price is a common way to quantify volatility, which is very different from expected loss.
What This Means for Investors
We could give endless examples of risk and volatility, but that provides no insight into why we often confuse the two concepts. When it comes to human interaction with the concepts of risk and volatility, context matters.
The risk that is significant to a person is relative to the context he or she puts around an idea. The volatility a person experiences is relative to how often he or she looks at their holdings and the markets.
Within everyone, the understanding of risk is governed by fear. Fear of missing out, fear of losing money, fear of going outside of a comfort zone, and the list goes on. These fears coupled with behavioral biases, including the herd mentality, loss aversion, and confirmation bias, work together to distort an investor’s ability to differentiate risk from volatility in the markets.
When our perception of risk is governed by the fear of losing money and behavioral biases, then volatility to the downside on a stock’s price causes us to think the stock is very risky. Meanwhile, volatility to the upside of a stock’s price is overlooked. This is how we often confuse risk and volatility.
Staying invested through volatility and managing risk are the keys to performing well in the long run. Regardless of whether it’s on your own or with an advisor, find a strategy that helps you become a more successful investor.
Recent articles by Judy Hulsey: Your Legacy: Tangible and Intangible Wealth
Christina Shaffer contributed to the writing of this article.
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