The Difference Between Volatility and Risk

By Dr. Sylvia Kwan

May celebrated the 125th birthday of the Dow Jones Industrial Index, the second longest running index in the world. (The Dow Jones Transportation Average is the longest.) Despite some swings during the month, the S&P 500 gained 1.9%. and the DJIA gained 0.9%, while the NASDAQ lost 1.5%, its first negative month this year.

With more than 40% of Americans fully vaccinated against COVID-19 and more than 50% having received at least one dose, people are feeling more comfortable going out in public and spending on restaurants, entertainment, travel, and other activities that have been largely paused since last year. The shift from buying goods to spending on services is evident in April’s consumer spending figures: Spending on services rose 1.1%, while spending on goods decreased 0.6%.

Bitcoin saw roller-coaster fluctuations this month, which has underscored the importance of understanding the difference between investment risk and volatility. Investors often confuse or equate the two. Both can make investors nervous, even fearful. But while intertwined, they are not the same. We can take actions and make decisions to mitigate one, while the other is largely out of our control. Understanding the differences between risk and volatility can help you make better investment decisions and keep your sights on the long term.

In its most basic form, investment risk is the likelihood of permanent capital loss. Risk can also describe the uncertainty of investment outcomes. The wider the investment’s range of possible outcomes, the greater its risk. Stocks are considered riskier than bonds, for example, because with stocks, you could end up with stellar returns or very poor returns. Meanwhile, bonds are unlikely to experience significant gains or losses: They won’t make anyone rich, but they are also unlikely to lose a significant portion of their value. So, while higher risk means more uncertainty and a larger probability of loss, it also means greater potential return for investors willing to take on that higher risk.

Investing involves other kinds of risk, too: market risk (how broader market conditions impact your investment), liquidity risk (how quickly and easily you can sell the investment), business risk (specific risks associated with the investment’s products or services), political risk (how government policies may impact the investment’s business or financials), and currency risk (if you hold foreign stocks), just to name a few. Even how long you hold an investment can mitigate or increase its risk: Stocks held for a short period (think days, weeks, or months) will involve higher risk than stocks you keep over decades. Historically, stocks have appreciated over long periods of time, so the probability of loss decreases with the length of your investment horizon. That’s why a portfolio with a high allocation to stocks is generally more suitable for longer horizons than for shorter ones.

We can’t eliminate risk, but we can mitigate and manage risk through asset allocation (aka the combination of stocks, bonds, and alternatives we hold) and diversification (holding many different kinds of investments). Specific risks associated with a single stock or class of assets can be offset by other investments that behave differently.

Meanwhile, volatility is a measure of an asset’s fluctuations in value — how quickly it changes, how often, and by how much. Bitcoin’s recent price swings are a perfect example of volatility. Bitcoin is currently down more than 50% from its mid-April high, and its value has dropped 37% since the beginning of May. During the last week in May, Bitcoin soared as high as $42,000 and dropped as low as $31,000. That’s a 30% swing in a single week, which also included a 40% drop in the span of 24 hours. The whiplash was driven partly by Elon Musk, Tesla’s CEO, when he tweeted that Tesla would no longer accept bitcoin as payment for its cars due to concerns around its energy usage. This led to speculation that Tesla might even sell the $1.5B in bitcoins it amassed in February. On top of this, Iran has banned bitcoin mining for the next four months due to power outages, and China has started cracking down on bitcoin mining and trading behavior.

Volatility matters most for short-term investors. Traders, for example, thrive on volatility — they use the frequent ups and downs to create opportunities for profit. For people like traders, high volatility and high risk are functionally identical, because high volatility increases their chances of losing money permanently. Volatility in itself doesn’t necessarily lead to higher returns, but if your horizon is short, it can lead to losses. That’s why, if you’ll need funds sooner rather than later, we don’t recommend allocating that money to equities.

But for long-term investors, volatility isn’t nearly as important. If you’re managing risk by allocating assets mindfully and mitigating risk by diversifying, you can decrease your probability of loss — volatility becomes less relevant. It determines only the bumpiness of the ride, and more often than not, it is temporary. Price movements from day to day, quarter to quarter, or even year to year don’t matter as much in the long run as the potential ending value of your portfolio. Ups and downs can be unnerving, but that’s the nature of investing.

Investors can ride out periods of volatility by having a concrete investment plan with the appropriate level of overall risk. Fluctuations can be nerve-wracking, and not having a plan can lead to poor decision-making, such as selling at an inopportune time and locking in losses. All investing entails risk, but if you’re a long-term investor, focus on matching your investment strategy to your goals’ timelines and don’t sweat the volatility.


© 2021 Ellevest, Inc. All Rights Reserved.

The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.

The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person.

Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Investing entails risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time.

Dr. Sylvia Kwan

Dr. Sylvia Kwan is the Chief Investment Officer of Ellevest.