Bad things happen when investors confuse risk and volatility. My clients have heard me say this several times over, and I’ve written about it in previous notes, but this is a very important topic we should periodically revisit. In my opinion, understanding the difference between risk and volatility is one of the most important things that separate the average from the above average investors.
Risk is what happens when you compromise your ability to reach your investment goal. At its best, too much risk means you don’t get the return you need from your investments. At its worst, it represents the chance of permanent loss of capital. Volatility, on the other hand, is a very different concept. It is the ups and downs on the way to achieving your goal.
Some investments can be volatile with low risk, while others can be highly risky with zero volatility. Sounds confusing, so here’s an example:
Let’s say an investor, 50 years old, needs to earn five percent per year to live the retirement of their dreams. Investing in the stock market to earn that five percent will certainly bring some volatility over the years, but it’s likely that over the long run that investor will earn the five percent per year they came for. So while the stock market can be volatile at times, investing for the long term is not a risky venture – with reasonable expectations it’s highly likely that the investor’s needs will be met. On the other hand, let’s say that same investor instead buys GICs or term deposits earning only two percent per year. Although there will be no volatility along the way, the investor is taking on significantly more risk than a stock market investment -- they will not meet their retirement obligations, falling short by three percent per year. Compound that three percent over the long run, and you have a very serious capital shortfall on your hands. Sometimes things that seem less volatile can make for the most risky investments of all.
The reason this is so important is that just about every investment will experience volatility at some point. Assuming that volatility equals risk encourages investors to bail on otherwise good investments at the wrong time. Just because an investment is lower than the purchase price does not necessarily make it more risky. In some cases, a lower price actually reduces risk when purchasing a high quality company because it increases the margin of safety or economic value. To reduce risk, the best thing investors can do is periodically revisit their long term needs and expectations. Those are the real drivers of investment satisfaction, and also the greatest opportunities for reward.