Your Money’s Silent Enemies: The Hidden and Often Misunderstood Relationship Between Investing Volatility and Risk!

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Investment volatility is a measure of how much the price of an asset fluctuates over time, while investment risk is the possibility of losing money due to factors affecting the overall financial markets.

Investors can choose to invest in high-volatility or low-volatility assets, depending on their risk tolerance and investment goals. High-volatility assets, such as stocks and emerging market bonds, tend to offer higher returns over the long term, but they also come with greater risk of loss.

Low-volatility assets, such as government bonds and cash equivalents, tend to offer lower returns, but they are also generally less risky.

It is important to note that volatility is not the same as risk. A highly volatile asset may not feel risky from a loss standpoint, if it is likely to appreciate in value over time.

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How Does Investment Volatility Work?

Investments come in all shapes and sizes, and each type has its own level of unpredictability. Some investments can go on a wild roller coaster ride, with prices swinging a lot in just a day, Others can be safer options that don’t jump around as much in the market. Take government bonds, for example — they are often like the calm waters where you pretty much know what to expect in terms of returns. It’s all about finding the right balance between excitement and stability based on what you’re comfortable with.

As an investment advisor portfolio manager, my main goal is to get the maximum level of return for clients, while minimizing the volatility and risk of loss in their portfolios, a challenge that can be viewed as simple — but definitely not easy!

So, when we talk about investment volatility, we’re looking at how much the prices of things like market indexes, specific securities, or a bunch of investments change over a certain period. It’s like a tool to measure how bumpy the financial ride has been.

This measurement isn’t just for people who love numbers, it’s a helpful way to determine how risky or uncertain an investment might be. The more the prices swing, the higher the volatility, which often means more risk is involved. It’s like a gauge to see if you’re in for a smooth cruise or a potentially rocky journey in the world of investments.

Alright, so let’s break down the jargon. Volatility is usually talked about using two main ways: either as a standard deviation or a percentage. If the volatility is high, it means the potential returns (the money you might make or lose) could be all over the place — both high and low. High volatility usually means there’s more risk involved.

On the flip side, if the volatility is low, it’s like saying, “Hey, things are staying pretty steady here.” This suggests the investment is more stable, with less bouncing around in prices. It’s often seen as less risky because you’re not likely to see big and sudden changes in your investment’s value. It’s like comparing a calm lake to a choppy sea in the investing world.

Investors and analysts find volatility very important for a lot of reasons, but here are five big ones:

1. Risk Assessment: Volatility serves as a stand-in for risk. Higher volatility suggests a greater chance of significant price swings, potentially leading to larger losses.
2. Portfolio Management: Understanding the volatility of individual assets is crucial for constructing well-diversified portfolios. Mixing assets with varying volatility levels as well as weightings in the portfolio aids in managing overall portfolio risk.
3. Option Pricing: Volatility plays a vital role in option pricing models. Options, which are financial derivatives, derive their values from the expected future volatility of the underlying asset.
4. Risk Management: Volatility measures are integral to risk management strategies, providing insights into the potential impact of different market scenarios on investment portfolios.
5. Market Sentiment: Changes in volatility can indicate shifts in market sentiment. Sudden spikes in volatility may suggest increased uncertainty or fear among investors, offering valuable insights into prevailing market conditions.

How Volatility Is Measured?

Investors employ diverse metrics to assess market volatility, and three prominent measures include:

1. Standard Deviation: This statistical tool quantifies the dispersion of values within a dataset. In financial contexts, it serves to gauge the degree of variation in a trading price series, providing insight into the historical volatility of an asset.
2. Beta: Functioning as a sensitivity indicator, beta measures the responsiveness of an investment’s returns to market movements. A beta exceeding one signals heightened volatility compared to the broader market, while a beta below one suggests a lower degree of volatility.
3. Volatility Index (VIX): Commonly recognized as the “fear index,” VIX assesses market expectations regarding future volatility. Calculated from the prices of options tied to the S&P 500 index, it offers an indication of anticipated market turbulence.

In the pursuit of effective risk management, investors leverage these metrics to discern and quantify the level of risk associated with specific investments, akin to employing navigational tools to navigate the complexities of the financial terrain.

What are some common risks that you should look at?

1. Market Risk: This is linked to overall market movements. Economic conditions, geopolitical events, and changes in interest rates are examples that can influence entire markets.
2. Credit Risk: This is the risk that the issuer of a debt security might not meet its obligation to pay interest and return the principal. Bonds or other debt instruments carry credit risk, and higher-risk bonds, like junk bonds, have a greater chance of default, posing potential losses for investors.
3. 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 face larger bid-ask spreads, especially during times of market stress.
4. Interest Rate Risk: Particularly relevant for bondholders, this risk arises from changes in interest rates affecting the value of fixed-income securities. Rising interest rates typically lead to falling bond prices, impacting the value of fixed-income investments.
5. 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 doesn’t outpace inflation, investors may experience a decline in real (inflation-adjusted) returns.
6. Currency Risk (Exchange Rate Risk): Changes in currency exchange rates can 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.
7. 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

Understanding investment volatility and risk is vital for your portfolio. Even though they’re a bit different, there’s a smart strategy to handle both: diversification.

Diversification means having a mix of different assets in your portfolio. This helps balance out the risky parts with others that are more stable, reducing the chance of big losses.

For example, stocks can be like a roller coaster with lots of ups and downs. But if you add in things like bonds, which are somewhat more predictable ( and likely to be inversely correlated), you can smooth out the bumps, especially when the market isn’t doing well.

Also, think about where you put your money. By spreading it across different types of investments and asset classes, like stocks or bonds and real estate, you’re lowering the overall impact when things get a bit shaky.

Make sure to keep this in mind: Diversification serves to mitigate the impact of poor performance within a singular asset class on the entire portfolio. Consequently, a meticulously balanced asset allocation, tailored to an investor’s risk tolerance and financial objectives, offers a strategic framework that typically facilitates better navigation through diverse market conditions. This ultimately elevates the overall stability and resilience of the portfolio.

In summary, an investment advisor, and or portfolio manager, employs data to assist clients in assessing market volatility and investment risk. Comprehending and managing both risk and volatility is crucial for investment success. Investors typically evaluate their risk tolerance and investment objectives to establish an optimal risk level for their portfolios. Commonly employed strategies for managing and mitigating investment risk include diversification, thorough research, and a carefully devised investment strategy.

BONUS TIPS for Investing!

An experienced investment advisor portfolio manager plays a crucial role in guiding you toward sound investment decisions aligned with your long-term financial goals. They possess the expertise needed to identify the optimal portfolio mix and can assist you in making necessary adjustments over time.

Fortunately, locating a qualified investment advisor portfolio manager doesn’t have to be a challenging task.

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Joe A. Macek, FMA, CIM, DMS, FCSI

Investment Advisor, Portfolio Manager

iA Private Wealth | iA Private Wealth USA

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