Traditional thinking emphasizes the difference between risk and volatility. Volatility refers to those (sometimes wild) upward and downward swings in stock prices or markets caused by events over which you, the investor, have little or no control. Risk, on the other hand, is a personal matter: It’s how much financial uncertainty you, personally, can tolerate without losing sleep at night.
New thinking, however, emphasizes the relationship between risk and volatility. Volatility can influence your perception of risk and motivate you to take actions that can hurt your investment returns.
“Volatility induces people to make poor investment decisions,” says Dan Hallett, vice-president and principal of HighView Financial Group in Windsor, Ont., and a blogger at the Wealth Steward. “That chips away at returns.”
The problem is that humans are often irrational. The chance of making a big score thrills us; we tell ourselves we can tolerate a little downside risk if there is big opportunity on the upside. But as investment veteran Mal Spooner points out, we are lying to ourselves. Once a stock price turns southward, most of us lose our taste for adventure. We panic and sell -- at the bottom. That’s called behavioural or execution risk.
“People have to be honest with themselves,” says Spooner, corporate finance professor at Humber College in Toronto, author of A Maverick Investor’s Guidebook and blogger at the Maverick Investors Rally Site. “That is very difficult.”
Volatility can be measured using standard deviation
Standard deviation indicates how much a stock price, a mutual fund return or a stock market index varies from its average, both on the upside and the downside. For example, if a stock has a standard deviation of 25%, it trades in a range 25% higher and 25% lower than its average price. If the bellwether composite index for that market has a standard deviation of 12%, you’re looking at a pretty volatile stock. And when it is down 25%, it can be hard to remember why you bought it.
Risk is subjective
There is no measure such as standard deviation for risk. Risk tolerance means different things to different people. “You don’t really know your tolerance for risk until you have knowingly been through it,” says Hallett, “until you have knowingly lived through losses.”
And age is a factor. In theory, the younger you are, the less affected you are by volatility. You can set your sights on long-term goals, more or less ignore the market’s gyrations and trust that investment returns will trend upward. You have time on your side. Conversely, the closer you are to retirement, the more vulnerable you are to volatility. You may not have the time to recover from a 25% drop in value.
That’s in theory. The reality is people, regardless of age, don’t like losses. “Investors tend to overweight recent experience disproportionately,” says Spooner. “If they have just lost money, they are extremely fearful of losing again.”
So, how do you adjust for the impact of volatility on your risk tolerance? First off, know thyself. Be honest with yourself: If you can’t stomach volatility, don’t buy volatile investments. If you think you need reinforcement, work with an advisor who can provide a voice of reason when you are about to make rash, emotional moves.
Or, take a lesson from Hallett: Purchase investments that are less volatile, that have lower standard deviations, such as balanced funds. Then you’re more likely to resist the impulse to sell when volatility erupts and you will hold onto the investment longer, which generally improves returns.
You can’t separate volatility and risk, but you can manage their impact on your investments.