Here are a few pointers that talks about Risk vs. Volatility
Risk vs. volatility may interest you as an investor. These find an important place in the domain of investment planning & personal finance. These indicate the dangers of venturing into financial markets. These tend to speak about the earning potential of the underlying investments. These convey the extent to which you would be able to gain or lose money.These are perceived differently by the investor fraternity. Some investors crave for them while others escape.
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Risk and Volatility lie at the heart of all kinds of financial analysis. You tend to use them to determine where you stand among particular investor categories. Apart from expected returns, these form the critical benchmarks while evaluating alternative investment opportunities. Moreover, these find an important place even in portfolio management. From asset allocation to re-balancing, risk and volatility act like your friend, philosopher and guides. So, ultimately you find that these terms heavily weigh on your returns.
Like most of the investors, you might have been using these terms interchangeably.
Now you may think were you wrong all these years?
These identical twins are not as analogous as they seem.
In fact, these have completely different interpretations and repercussions on the overall investment outcomes.
So, as a prudent investor, it’s time to know what makes Risk and Volatility different.
Risk and Volatility- A Prologue
Risk refers to the probability of loss. You are usually surrounded by a variety of risks like meeting an accident or your house catching fire. In the world of finance, risk indicates the permanent loss of capital in an investment. If you look into the fundamentals of a company or a country, then you can easily ascertain its ability to lose or make money. The risk is inversely related to time. The longer you stay invested, the shorter becomes your probability to lose money in an investment.
Volatility implies the fluctuations in the price of an investment over its entire life. You may know about the average returns from an investment. Volatility refers to the scatteredness or dispersion of actual returns of investment from its mean returns. In simple terms, it is the Standard Deviation or Variance of the security. It shows the variability in the returns in both the negative as well as positive direction.
For, e.g., Consider mean returns of security is 12% while volatility is 6%. It shows that you may get returns somewhere in the range of 6% to 18%.
Volatility can be absolute as well as relative. Standard Deviation gives you absolute volatility while Beta is about relative volatility. Beta points to the degree of fluctuations experienced by security on movements of the benchmark index.
A beta of 1 means that the security moves in line with the index. A beta>1 say 1.1 indicates that security moved 110% for every 100% movement in the index. A beta <1 say 0.8 shows that the security moved 80% for every 100% change in the index.
Usually, investors with a low-risk appetite go for investments with low volatility. Conversely, risk seekers can stomach violent fluctuations in the price of their investment.
Also read: Growth vs Dividend: Which one to choose?
Volatility doesn’t always amount to Risk
To champion the market and come out with heavy kitty, you got to ward off this basic misconception. People think that investments that are volatile like stocks would surely amount to losses. What they are unable to comprehend is that volatile instruments may not necessarily sink their invested capital.
Let’s understand this with an illustration.
Suppose there are two investors John and Robert. John is a value investor who probes the company fundamentals before investing. Robert, on the other hand, relies more on financial models to make investment decisions. Both of them are eyeing to buy stocks of Ferns & Petals Inc. Currently, the stock of Ferns & Petals sells at Rs 100. Looking at strong fundamentals, John expects the undervalued stocks to rally in future. But financial models exhibit it as a risky investment to Robert. Robert abstains from buying the shares, but John invests in it. Over a period, the share prices rise to Rs 150. John books his profit while Robert loses an opportunity.
It’s more about the timing and less about the volatility. If you cash in on the right time, even high volatility would have high payoffs.
On the other hand, Low Volatility does not convey low risk. An instrument whose price was seemingly stable may suddenly plunge on account of unexpected events. A bankruptcy filing or sudden litigation could trigger selloffs which may cause the share price to fall to unimaginable levels.
Risk vs. Volatility – A Difference of Opinion
You may still be puzzled whether these two identical twins are anyhow different. But believe me, your journey to success lies in getting to the core.
Let’s look at some of the major differences in Risk and Volatility:
Can you measure Risk?
Now that’s an intrigue in itself!
Analysts have for long used Standard Deviation and Variance to measure risk. But they are, ultimately wrong. Risk cannot be measured in real terms. When you invest money in stocks, you cannot predict with certainty the extent to which prices are going to drop. You can’t claim whether you will lose 20% or 30% or even more.
Aye, you cannot calculate risk for sure!
On the contrary, the fluctuations in price or Volatility can be measured using Variance. You can estimate to what extent the returns of the security have swayed from its average. Based on that, you may deduce the riskiness of the investment. And also, whether or not it’s meant for you.
To you, midcap stocks may be the best bet. But your neighbour may consider it precarious for his financial health. Conversely, your friend may find mid caps little less preferable but may not entirely avoid it. Now, for the same instrument, there lies such a huge perceptual difference.
Here, I am referring to the risk appetite or the willingness to stomach the loss of money. So, now you may have understood that risk is a widely subjective thing. Investors may invest in different proportions in the same instrument.
Now let’s move to volatility. When you or your friend calculates the variance of the mid caps based on historical returns, you get the same result. It means that the volatility of midcaps remains the same irrespective of your perceptions or investing attitudes.
Hence proved that risk is a subjective matter whereas volatility is very much objective.
“What will I gain and how much am I gonna lose in this?” That’s the first question that pops in your mind while investing. So, here you are trying to gauge the risk inherent in the underlying asset. You are focusing on its earning potential or cash-burning potential in future. You are concerned about what the financial future is going to look like?
Then, you go on to check its volatility. You dig out the historical returns and put them to statistical treatment. Now, you got an estimate of how much the investors might have lost/gained before.
Thus, Volatility is a historical concept. Risk relates to your condition in the future.
The Good thing and the Bad thing
From the very outset, I relate risk to something very unfortunate. It is synonymous with loss. You are only looking at the downside. In risk, there’s no reference of the good things and no happy endings.
But, on the contrary, when I referred to volatility, it was both about the good thing & the bad thing. In fact, the entire range within which you may expect your returns to occur. Volatility takes into account both the positive and negative deviations from the mean.
Therefore, risk equates itself to the downside of an investment. However, Volatility embraces both the upside and downside of an investment.
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Risk vs. Volatility are entirely different concepts. Volatility is an indicator of risk inherent in an instrument but is not risk in itself. The earlier you get fundamentally sound on these, the more moolahs would you be able to mint.
Very informative and useful Post. The difference between the twins explained with birthmarks !!!