Investment volatility signifies the degree of change in the trading price of a financial instrument over time. Investment risk, on the flip side, relates to the potential for losses due to factors that affect the overall performance of the financial markets. So, if you prioritize steady returns, you might opt for investments that are less likely to be impacted by changes in the market or have low volatility, and are also less likely to carry high returns. Here’s what you need to know about investing and risk.
A financial advisor can help you measure risk throughout your portfolio while still hitting your long-term goals.
How Investment Volatility Works
Every type of investment carries different levels of volatility. Some investments can change drastically in price, even in one single day. While other investments that are considered safer, tend to have less market volatility. One example of a safer investment typically includes government bonds, as investors know what to expect with their returns.
Investment volatility therefore measures different levels of price fluctuations for a given market index, security, or investment portfolio over a specific period of time. This is a statistical measure that is also commonly used to assess the risk or uncertainty associated with an investment.
Volatility is often expressed as a standard deviation or a percentage. Higher volatility indicates a greater range of potential returns (both positive and negative) and is generally associated with higher risk. Lower volatility suggests a more stable investment with less price fluctuation and is often perceived as less risky.
Investors and analysts use volatility as a key metric for these five common reasons, among others:
- Risk assessment: Volatility is a proxy for risk. Higher volatility implies a higher likelihood of large price swings, which may lead to higher potential losses.
- Portfolio management: Understanding the volatility of individual assets helps in constructing diversified portfolios. Combining assets with different levels of volatility can help manage overall portfolio risk.
- Option pricing: Volatility is a crucial input in option pricing models. Options are financial derivatives whose values are influenced by the expected future volatility of the underlying asset.
- Risk management: Volatility measures are used in risk management strategies to assess the potential impact of different market scenarios on investment portfolios.
- Market sentiment: Changes in volatility can reflect shifts in market sentiment. Sudden increases in volatility may indicate increased uncertainty or fear among investors.
How Volatility Is Measured
Investors have different ways to measure volatility. Three common measures include:
- Standard deviation: This is a statistical measure that quantifies the amount of variation or dispersion of a set of values. In the context of finance, it measures the degree of variation of a trading price series.
- Beta: Beta measures the sensitivity of an investment’s returns to market returns. A beta greater than one indicates higher volatility than the market, while a beta less than 1 suggests lower volatility.
- Volatility index (VIX): Often referred to as the “fear index,” the VIX measures market expectations for future volatility. It is calculated based on the prices of options on the S&P 500 index.
How Investment Risk Works
If investment volatility measures unpredictability, investment risk aims to measure the uncertainty or potential for financial loss in an investment. This is a multi-faceted concept that encompasses various factors that could negatively impact the expected returns of an investment.
Some common risks that investors consider include:
- Market risk: Market risk is associated with overall market movements. Economic conditions, geopolitical events and interest rate changes are examples that can affect entire markets.
- Credit risk: This is the risk that the issuer of a debt security may not fulfill its obligation to pay interest and return the principal. Bonds or other debt instruments, for example, carry credit risk. And higher-risk bonds (e.g., junk bonds) have a greater chance of default, leading to potential losses for investors.
- Liquidity risk: This is the risk that an asset cannot be quickly bought or sold in the market without affecting its price. Less liquid investments may be harder to sell at desired prices, and investors may incur larger bid-ask spreads. This can be a concern, especially in times of market stress.
- Interest rate risk: This risk is particularly relevant for bondholders as changes in interest rates will affect the value of fixed-income securities. Rising interest rates typically lead to falling bond prices, impacting the value of fixed-income investments.
- Inflation risk: This is the risk that the purchasing power of money will decrease over time due to inflation. If the rate of return on an investment does not outpace inflation, investors may experience a decline in real (inflation-adjusted) returns.
- Currency risk: Also known as exchange rate risk, this is the risk that changes in currency exchange rates will impact the value of an investment. For investors holding assets denominated in foreign currencies, fluctuations in exchange rates can affect returns when translated into their home currency.
- Business and financial risk: These are specific to individual companies and can include operational challenges, financial mismanagement, or other company-specific issues. Investments in individual stocks carry company-specific risks that may impact the performance of the investment.
Managing Risk and Volatility
Both investment volatility and risk reflect different levels of uncertainty for investors. However, there are some key things that you should note for your portfolio.
While volatility represents the short-lived highs and lows in the cycle of an investment, risk encompasses the chances of an investment’s actual return not matching up to expectations. But in spite of this key difference, one strategy can help investors manage both: Diversification.
Managing risks through diversification involves holding a variety of assets under your belt. This ensures a mix of assets with different levels of risk. The aim of the strategy is to offset potential investment losses with other potential wins.
Stocks, for example, are known for their higher volatility and could experience significant price fluctuations. But by adding less volatile assets like bonds, you can aim to offset potential losses during market downturns.
Similarly, you can focus on your asset allocation to help protect your portfolio from investment volatility. In doing so, you would also diversify investments across different asset classes, each with its own risk-return profile. So again, this would mean spreading investments across different assets like stocks or bonds, among other investments, so that the overall impact of volatility can be mitigated.
Take note: Diversification reduces the risk of the entire portfolio being adversely affected by the poor performance of a single asset class. Therefore, a well-balanced asset allocation aligns with an investor’s risk tolerance and financial goals, providing a strategic approach to navigate varying market conditions and enhance the overall stability and resilience of the portfolio.
Bottom Line
Understanding and managing both investment risk and volatility are key for the success of your investments. Investors often assess their risk tolerance and investment goals to determine an appropriate level of risk for their portfolios. Diversification, thorough research and a well-thought-out investment strategy are common approaches to managing and mitigating investment risk.
Tips for Investing
- A financial advisor can help you make the right investment decisions that tie into your long-term financial plan. They have the experience necessary to help you find the right portfolio mix and can help you adjust over time. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When trying to diversify your portfolio, you might want to make sure your portfolio is well-balanced. You can use SmartAsset’s free asset allocation calculator to see what a portfolio breakdown could look like for your chosen level of risk.
Photo credit: ©iStock.com/g-stockstudio, ©iStock.com/GaudiLab, ©iStock.com/Jirapong Manustrong