Volatility vs. Risk: Why You Need To Understand the Difference
I remember doing some basic geometry in grade school (probably 3rd grade or so) when the teacher threw a bit of a mind-bending fact at us.
She said, “Remember students, a square is a rectangle, but a rectangle is not a square.”
Truthfully, most of us understood the distinction, but I remember my teacher tossing it our there like it was a fascinating riddle.
Anyhow, I’ll spare you an explanation of the similarities and differences between rectangles and squares because I am assuming you already know that.
The reason I’m bringing it up is that it will serve as a helpful metaphor as we outline the similarities and differences of volatility and risk.
All too often, these words are used interchangeably in the world of finance, but each has specific characteristics that we should understand so that we don’t overreact to one or the other.
Let’s walk through the details of each of these concepts to better understand why they need to be viewed distinctly.
What is Risk?
In a financial sense, risk is the possibility that you won’t be able to meet your financial goals due to an unforeseen change.
There are many types of financial risk:
- Credit risk
- market risk
- timing risk
- sequence of returns risk
- currency risk
- concentration risk
- political risk
- liquidity risk
- systematic risk
- inflation
- legal risk
- strategic risk
- and I’m sure there are many others
Putting it in a list like this kind of makes you wonder how safe your money really is, doesn’t it?
Or maybe, if you understand these risk factors, it doesn’t concern you much at all.
The truth is, risk is inherent in nearly anything we do, there are just more PhDs in the world creating names for financial risks, so it seems like your money is in greater danger.
Some examples of investing risks:
- Firestone had to recall millions of tires in the late 90s because of a manufacturing defect. Their stock didn’t do so well through that.
- Tobacco companies were once big stocks until we all wised up to the fact that their products kill people.
- Bonds haven’t exactly done well with rising interest rates over the last year, have they? For that matter, the stock market didn’t seem enthralled either.
- There were a lot of hedge funds that shorted GameStop and AMC during the COVID lockdowns. A bunch of internet stock gangsters colluded to drive the price of those stocks up forcing those who shorted the stocks to buy them back at exorbitant prices. Ouch.
- Speaking of COVID, I hope you didn’t sell everything in the middle of March 2020. Bad timing could have cost you big time.
- Suppose you’re more conservative and left all of your cash in high-yield savings. I doubt that the account was able to keep pace with inflation in 2021 and 2022.
Risk is everywhere. We can’t ever totally escape risk; we can only establish strategies to mitigate it.
I’m not writing this post to address specific risks. I just wanted to provide a few examples to show how abundant risk is.
If you want to learn more about managing investing risk, I’d invite you to read our post about asset allocation.
What is Volatility?
For the purposes of this article, volatility is the measure or how much the price of an investment increases or decreases relative to its average price.
Beta is a common tool used to quickly evaluate the volatility of a stock relative to changes in the overall market.
If a stock’s beta is greater than 1.0, then the stock has above-average volatility. If the beta is under 1.0, the stock has less than average volatility.
If a stock has a beta of 2.0, then that stock is twice as volatile as the stock market as a whole.
Volatility is higher in stocks than in most other investments because stocks trade more easily and frequently.
When I wrote this in late May 2024, the Nasdaq’s 10-day average trading volume was just under 16 million trades per day. The NYSE was around 4.3 million.
To be clear, that’s trade contracts, not the number of shares traded, which is over 1 billion per day for both exchanges.
Every time a stock is traded a buyer and a seller reach an agreement on a sell and purchase price. This process is almost always managed by market makers that connect buyers and sellers on an exchange.
Most trades occur at a price that is either above or below the trade that occurred previously, and every time that happens it moves the price of the stock up or down.
That’s why the price of a stock is always moving if you watch a ticker. The ticker simply reflects the latest trading activity for the stock.
This constant movement is the primary contributing factor to beta. The other is how far up or down the price moves as a result of trading activity.
Clearly, the prices of some stocks travel much further from their daily starting points than others.
Generally speaking, the easier an investment is to trade the more volatile it tends to be. Since stocks are easily traded on an exchange that can be accessed by nearly anyone from almost anywhere on Earth, stocks tend to be more volatile than many other investments.
Volatility Can Be Risky, But Not Always
“That’s great, Curt. I see the distinction, but why does this matter?”
The problem is many times people confuse volatility with risk, which could potentially discourage them from buying an investment they would be better off holding.
To help unpack this, let’s look at an example comparing two investments with very different levels of volatility.
Take a look at this chart comparing the performance of Vanguard’s Total Stock Market Index Fund (VTSAX) and Vanguard’s Total Bond Market Index Fund (VBTLX).
Note how the price movement of the stock fund has been more active (i.e. – volatile) over the preceding three months than the bond fund. The daily ups and downs of the stock fund are clearly larger based on this visual illustration.
To me, it looks like each investment spent about as much time going up as it did going down, but the rises and drops were much more significant for stocks.
A common conclusion from a graph like this is that stocks are riskier than bonds, and if you were trading these two funds on a daily basis, then you’d be absolutely right.
Just based on three months of activity, it is clear that if you lose money from one day to the next while holding the bond fund your losses will be more limited than they would be in the stock fund.
But what if you held these investments longer? Would that change the level of risk even if the volatility remains?
My personal belief is that, over long periods of time, the bond fund exposes you to more risk.
Next, let’s just look at the performance over the last 5 years…
Once again, the bond fund has been much less volatile—no doubt about that.
What should be painfully obvious to you now, however, is the fact that the performance of the stock fund has been remarkably better (17.3% vs -2.55% annualized)
And in case you’re concerned that I’m stacking the deck by choosing a favorable date range to make a point, here is the graph going back to 2001…
There’s no contest here. Even with the lost decade for stocks, their annualized returns were 17.77% over this period while bonds returned -0.32%.
Inflation during this period was 3.38% annually, which is also the basis of my argument that, over the long-term, bonds are riskier than stocks.
By extending the investment horizon, the risk of inflation grows in importance (even if it has been there all along).
The bottom line is no one can indefinitely afford to accept returns that are outpaced by inflation.
Stocks are clearly a suitable way to address inflation, but bonds are…dare I say…risky?
And I’m not even planning on addressing the risk that you won’t have enough saved and invested to retire.
The Time Value of Volatility
So, just like a rectangle is also at times a square, volatility can be a contributor to risk, but just because an investment is volatile that doesn’t mean it’s risky.
As it turns out, time is the ultimate anecdote for volatility. From a broader perspective, we can see that the daily ups and downs just aren’t as important as net gains.
Stocks provide a much better option for outpacing the impact of inflation. If you have a lot of time, bonds are just too risky.
In fact, I would even be willing to argue that, again, over the long term, stocks are a relatively low-risk investment.
But how long is “long-term”?
For me, if you’re talking about a diversified portfolio of stocks that you are no longer contributing to, seven years is a sufficient period to outlast an extended dip in the stock market.
If you’re continually buying more diversified stock funds, then 5 years is sufficient because dollar-cost-averaging reduces the risk that you’ll buy at the wrong time.
On average, the stock market has a down year 2 out of every 10 years. Of course, that could mean 4 bad years in a row out of 20, so it’s not as if the risk is non-existent; it’s just much lower with more time.
Another thing I’d like to point out from the graphs is the way time has had a smoothing effect on the volatility of stocks.
Don’t get me wrong, the day-to-day volatility is still there, it’s just harder to notice when we scale back to a broad number of years.
I like to picture stocks like a mountain road. There may be some bumpy patches and there will certainly be ups and downs, but overall, the journey is going higher and higher.
Bonds are more like a street in a boring neighborhood. It’s safe, well-lit and smooth, but the ride just isn’t that impressive and certainly isn’t one you want to be on for an extended period.
Bonds are great for getting you through intermediate periods of two to five years where you just can’t accept the risk of a sudden, hard downturn in the value of your stocks.
But, for those of us who are trying to build adequate portfolios for retirement, bonds are not the best long-term option.
Conclusion
Again, I don’t want to come across as a bond hater. There is certainly a time and place for bonds, but I do want to challenge the idea that stocks are risky and bonds aren’t.
There are plenty of examples where this statement is true and plenty where it is false.
As usual, the devil is in the details. Hopefully, distinguishing the differences between volatility and risk makes that much clearer.
For more about asset allocations and the use of bonds, I’d invite you to read about why I don’t currently own any bonds or watch the YouTube version.
