What’s the Difference and How Do They Impact Your Portfolio?
Volatility and risk. When it comes to investing, those two terms mean the same thing, right? Not exactly. While volatility and risk can both refer to market downturns, they don’t have the exact same meaning. Understanding the difference between volatility and risk can help you make more informed investment decisions and implement the right long-term strategy for your needs and goals.
What is volatility?
Volatility is a statistical measure of the dispersion of returns for a given security or market index.1 In simpler terms, it’s range of returns that could be expected for a stock, bond, mutual fund, or other investment.
Volatility is often measured by something called standard deviation, which is the variance of returns for a specific investment. For instance, assume a stock has a historical average return of 8% annually with a standard deviation of 10. The average return is 8%, but you could expect returns in any given year as low as 10% below the average or 10% above the average. So the annual returns will usually fall somewhere between -2% and 18%.
Now consider a stock that has an average annual return of 6% with a standard deviation of 4. In this example, the annual returns will usually fall somewhere between 2% and 10%. Clearly, this stock is less volatile than the previous example.
Volatility refers to the potential downside, but it also refers to the potential upside as well. Volatility is a natural part of investing. Securities increase in value some days and decrease other days. It’s difficult to avoid volatility, but you can manage it by knowing your own comfort level and choosing investments that align with your tolerance.
What is risk?
Risk is different than volatility in that risk refers specifically to loss. It’s generally the possibility of loss. There are a few measurements that can be used to estimate your investment risk, like standard deviation, but there isn’t one objective way to measure your level of risk exposure.
Instead, the best way to measure and manage risk is often through careful, regular analysis. Your tolerance for risk is unique and subjective. The amount of risk that is too much for you may be perfectly fine for another individual. Only you can truly know what level of risk is appropriate for your strategy.
However, a financial professional can help you determine your risk tolerance and analyze your current exposure to market risk. It’s possible that a more conservative allocation could be appropriate. Or you might benefit from financial vehicles that don’t have any market risk exposure. Since risk is such a subjective term, it often takes regular monitoring, review, and adjustment to find the right strategy.
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