Volatility vs Risk
The difference between volatility and risk is one thing that investors often confuse. It doesn’t help that sometimes professional investors and software tools may even interchange the terms.
This reminded me of an experience I had several years ago. I met with an institutional investor who worked with Benjamin Graham, widely considered to be the “father of value investing.” This investor clearly delineated between risk and volatility. He claimed that volatility is part of the journey and something we should welcome, possibly to buy in at lower than normal prices, whereas risk is the permanent loss of capital.
I liked how he explained it, but it feels like the definition needs to be even clearer for investors. Volatility, after all, can lead to permanent risk of losing capital if a company cannot pay off its debts by additional capital raises. Quants (quantitative analysts) or financial risk managers may look at volatility and “market risk” as the same since they consider market risk to be a measure associated with standard deviation, value-at-risk, or “risk” models such as GARCH (generalized auto-regressive conditional heteroskedasticity – try saying that at a cocktail party!) or EWMA (exponentially weighted moving average) that are used to forecast volatility.
So let’s first break these up into financial risks, of which market risk is a part of. While there are many different types of risks, including business risk, compliance risk, operational risk, reputational risk, we will only be looking at financial risk below.
- Financial risk includes:
- Market risk – this has to do with price volatility.
- Credit risk – this has to do with the probability of a company defaulting on its debts or getting downgraded by a credit rating agency and is related to fixed income assets.
- Interest rate or duration risk – this has to do with the impact that rising interest rates will have on the value of fixed income assets.
- Liquidity risk – this has to do with the ability to sell an asset when few buyers want to buy it and can include any asset that can be traded.
- Currency risk – this has to do with how currency changes can impact the value of an asset when translated back into US dollars.
- Country risk – this has to do with how specific challenges a country is facing may impact the price of assets from that country. This could relate to inflation in that country or other financial risks such as credit risk, liquidity risk, currency risk, and market risk.
- Correlation risk – this has to do with the risk that one asset is highly correlated with another asset and may go down simply because they behave similarly. This could also be a result of a crowded trade where many investors are in the same types of positions and they decide to exit at the same time.
- Contagion or systemic risk – this is the risk that the volatility of one asset class or sector spills over into one or more other asset classes or sector. For example,
So how should we look at market risk or volatility?
If this is not a permanent risk of capital, we should view it more in terms of what volatility one is comfortable with and what volatility one is capable of taking on. Investors are often profiled using a questionnaire or a software to gauge how comfortable they are with market risk or volatility. This is often done looking only at willingness to take on risk and not the ability or capacity to take on risk.
What do we mean by capacity to take on risk? Think of an individual who is fast approaching retirement and who needs to start withdrawing a significant amount from their portfolio soon. This individual may be perfectly willing to tolerate the higher volatility of an aggressive portfolio. But there is now a greater risk that they withdraw large sums of money out of their portfolio while markets are falling significantly. This could impact the total amount of funds that they would have access to in retirement. This is what we mean by capacity to take risk. If they didn’t need the money and they didn’t need to make any withdrawals, that changes the capacity to take risk quite a bit and market volatility can later lead to higher values.
When we pair long-term goals and a financial plan with willingness to take risk, we can see the difference between willingness to withstand volatility and ability to withstand volatility. CFA Institute recommends that we should honor the lower of the two measures. If someone has a high willingness to take on market risk, but low ability, we should honor their lower ability to take on that risk. If someone has a high capacity or ability to take on risk, but they don’t have the willingness or comfort to take on the volatility, we should honor their lower willingness to take on the volatility.
There is one more thing we should mention about market risk and that relates to market risk that is diversifiable and market risk that is not diversifiable. Diversifiable risk is also called systematic risk and market risk that is concentrated to one or just a few positions is called unsystematic risk or idiosyncratic risk. Despite concerns we may have over taxes, we should be aware of the significant risk that we take on when we hold very large positions in one company. We may have heard of individuals that were holding very large positions in Enron, Worldcom, or Lehman Brothers stock before they went bankrupt. These were all very large respectable companies that were, at one point, considered stable and not overly “risky.” Large stockholders who held concentrated positions to the end lost virtually everything.
If someone owns a very large position in a company, let’s say 50% of their portfolio, there is a very high degree of market risk related specifically to that company and not the entire stock market. It’s quite possible for the stock market to increase by 20% and for the company’s stock to drop 20% or more within the same time frame. If the company was a small position, let’s say just 2-4% of the total portfolio, a significant drop in the stock price would not have a massive impact on the total portfolio, since it is diversified with many other holdings.
There are many types of risks. There are even several different types of financial risks. But market risk has to do with market volatility. Investors should be aware of both their capacity or ability to take risk as well as their willingness or comfort to take risk. We should err on the conservative side by looking at the lower of the two measures when looking at a portfolio.
Where possible, we should seek to limit the amount of concentrated or undiversifiable market risk we are exposed to. This will better allow us to weather a market downturn, where many stocks may fall some in value, rather than a specific risk to one company where the drop in value could be much more severe.
Jim Worden is solely an investment advisor representative of WCG Wealth Advisors, and not affiliated with LPL Financial. Any opinions or views expressed by Jim Worden are his own and are not those of LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All performance referenced is historical and is no guarantee for future results. All indices are unmanaged and may not be invested into directly.