Risk is ever-present in investing, regardless of what type of securities or assets you may have in your portfolio. That means there is a possibility that unexpected market events could lead your holdings to lose some or all their value.
Volatility is another factor that you need to consider when you’re buying or selling investments. The value of any security doesn’t remain unchanged for long periods, and profits or losses can sometimes reach an amount significant enough to put even experienced investors on edge.
While risk and volatility tend to be used interchangeably, they are two completely different investing concepts. Let’s find out more about their differences.
Investing Risk Explained
Risk in investing and finance refers to a security’s potential to lose some or all of its value. It is the probability that an investment will not be able to meet the expected return.
Risk and return are highly correlated in investing. The higher the potential return of an asset, the higher the risk. As a result, investors seek more returns from shouldering more risk because they choose to accept more losing odds.
Risk often means the chance of losing money. However, “upside risk” refers to the chance of security generating a higher-than-expected return.
Managing Investing Risk
Investors can manage investment risk in two ways: asset allocation and diversification.
Asset allocation helps you determine which investments you should divide your money across. It involves building an investment portfolio capable of striking a balance between risk and return.
Usually, a portfolio manager tweaks the asset allocation percentage according to the investor’s risk tolerance.
On the other hand, diversification is putting your investment dollars into different securities and asset classes that do not correlate. That way, some investments’ gains can offset others’ losses in the portfolio.
Types of Investing Risk
Investing risks come in many different forms, with some of the common ones including:
Business risk is when a company might fail to meet its financial obligations to its stock and bondholders.
Shares of stock serve as an investor’s piece of ownership in a publicly traded company. At the same time, bonds allow companies to borrow money.
Shares and bonds remain valuable as long as the issuing company stays solvent. However, if the firm is liquidated, its shares could lose value, making the stock completely worthless.
The company’s assets and operations are sold, with the proceeds going first to creditors, including bondholders. In contrast, any remaining proceeds will go to the shareholders.
Liquidity risk is the risk of investors failing to buy or sell investments at a time of their choosing. The possibility that they will not be able to sell security raises their potential losses. At the same time, their failure to make a buy can lead to them missing out on an opportunity.
Interest Rate Risk
Interest rate risk is the probability of an investment losing value due to changes in the interest rate.
Central banks worldwide are in charge of setting the monetary policy in their respective nations. They adjust interest rates to accelerate or slow down an economy as much as necessary.
Inflation risk is the potential of reduced purchasing power due to the value of investments being unable to keep up with surging prices across the economy. It is the possibility that higher prices will gradually lessen your investment returns.
Political risk involves an investment’s value or returns possibly weakening due to political changes or lack of support in the economy.
Companies or investors operating and trading across overseas markets usually deal with this type of investing risk. Currency risk is the possibility that you will lose money if the currency’s value in the foreign exchange (forex) markets moves unfavorably.
Commodity risk is the risk that a company’s stock price will be hurt due to fluctuations in raw materials prices.
Market Volatility Explained
Market volatility represents the fluctuation rate in an investment’s price over time. It measures the speed, frequency, and amount of the changes in an asset’s price. Simply put, volatility determines how severe or fast an investment’s price may change.
Market volatility is usually associated with investing risk, but it can also help investors secure better returns. Short-term traders see volatility as a sign of higher returns and a higher risk of losing, while speculative traders consider volatility as the core driver of their profits.
Overall, volatility focuses on price changes of an investment, not its values. It’s important to know that price and value are two different things in investing.
While the security price could fluctuate uncontrollably, the firm’s value can be unaffected. The change only occurs at the price that investors are willing to pay to buy the intrinsic value, and prices can undergo drastic changes depending on the state of the market.
Market volatility is not much of a worry for long-term investors, as short-term price fluctuations typically even out over time, driving many to bet more on stocks.
But as they near retirement, they make fewer investments in stocks and more in bonds, which are less volatile than stocks but have a risk of different degrees.
In addition, market volatility is easier to quantify and measure than investing risk as it is clearer and more objective. Investing risk is more subjective, making it quite hard to quantify and measure.
Managing Market Volatility
The best way you can manage market volatility is to stay invested and simply don’t pay much attention to it.
Volatility should not be a concern if you’re the buy-and-hold type of investor. By riding out market volatility and staying invested, you avoid short-term losses you may have incurred if you made an ill-timed exit from the market.
Some investors believe they can participate in and back out of the market during favorable conditions. Still, timing the market rarely works and is pretty hard to pull off. That is why this type of approach often later leads to more losing investments than winning ones.
Still, that doesn’t mean there’s no benefit to volatility. Instead of value, market volatility is based on insight. And a decline in stock prices can offer the opportunity to own stocks at a discount. However, that only becomes an opportunity if you have grasped the asset’s underlying value well.