Volatility Is Not Risk, the Two Should Not Be Confused
What is risk? To the conservative investor, risk is a negative to the opportunistic investor, risk is a factor to tolerate and accept. Whatever the perception of risk, it should not be confused with volatility. That confusion occurs much too frequently.
Volatility can be considered a measurement of risk, but is not risk itself. Many investors and academics measure investment risk in terms of beta; that is, in terms of an investment’s ups and downs in relation to a market sector or the entirety of the market. If you want to measure volatility from a very wide angel, you can examine standard deviation for the S&P 500. The total return of this broad benchmark averaged 10.1% during 1926-2015, and there was a standard deviation of 20.1 from that average total return during those 90 market years.(1)
What does that mean? It means that if you add or subtract 20.1 from 10.1 you get the range of total return that could be expected from the S&P two-thirds of the time during the period from 1926-2015. That is quite a variance, indicating that investors should be ready for anything when investing in equities. During 1926-2015 there was a 67% chance that the S&P could return anywhere from a 30.2% yearly gain to a 10.1% yearly loss. Again, this is total return with dividends included.(1) Just recently, there were years in which the S&P’s total return fell outside of that wide range. In 2013, the index’s total return was +32.39%. In 2008, its total return was -37%(2) When statisticians measure the volatility of major indices like the S&P 500, Nasdaq Composite or Dow Jones industrial Average, they are measuring market risk. Tring to measure investment risk is another matter.
You can argue that investment risk is not measurable. How can investors measure the probability of a loss when they invest? Even after they sell an investment, can they go back and calculate what their risk was at the time they bout it? They only know if they made money or not. Profit or loss says nothing about risk exposure.
Most experienced investors do not fear volatility. Instead they fear loss. They think if “risk” as their potential for unrecoverable loss. In reality, most apparent “losses” may be recoverable given enough time. True unrecoverable losses occur in one of two ways. One, an investor sells the investment for less than what he or she paid for it. Two, some kind of irrevocable change happens, either to the investment its
elf or to the sector to which the investment belongs. For example, a company goes totally out of business and leaves investors with worthless securities. Or, an innovation transforms an industry so profoundly that it renders what was once a leading-edge company an afterthought.
Diversification helps investors copy with volatility and risk. Spreading assets across various investment classes may reduce a portfolio’s concentration in a hot sector, but it also lessens the possibility of a portfolio being overweighted in a cold one. Volatility is a statistical expression of market risk, constantly measured. Volatility, however, should not be confused with risk itself.
Vision Financial Group
4505 Pine Tree Circle, Birmingham, AL 35243
This material was prepared by MarketingPro, Inc. Bill Dowell is a Registered Representative of ProEquities, Inc., A Registered Broker-Dealer, Member FINRA & SIPC. Vision Financial Group, Inc. is independent of ProEquities, Inc.