Understanding Investment Risk and Volatility: What You Need to Know
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There is a risk to your capital and you may not get back the full amount invested. The value of investments, as well as the income from them, can fall as well as rise.
When investing, two key concepts that often come up are investment risk and volatility. While they are closely related, they are not the same thing. Understanding the difference between them can help you make more informed investment decisions and build a portfolio that aligns with your financial goals and risk tolerance.
What is Investment Risk?
Investment risk refers to the potential for losing money or not achieving your expected financial return. Every investment carries some level of risk, but the degree of risk varies depending on the type of asset and market conditions.
The main types of investment risk include:
Market Risk: The risk of investments losing value due to economic downturns, political instability, or market crashes.
Inflation Risk: The risk that the purchasing power of your money will decrease over time if investments don’t grow faster than inflation.
Interest Rate Risk: The risk that rising interest rates will negatively impact the value of certain assets, particularly bonds.
Liquidity Risk: The risk of not being able to sell an investment quickly without taking a loss.
Credit Risk: The risk that a bond issuer might default on its payments.
Some assets, such as stocks, tend to have higher investment risk than others, such as government bonds or cash savings. However, higher risk investments also tend to offer the potential for higher returns over the long term.
What is Volatility?
Volatility refers to how much the price of an investment fluctuates over time. The more an asset’s price moves up and down, the more volatile it is. High volatility means prices can change dramatically over short periods, while low volatility means prices are more stable.
Volatility is often measured by standard deviation, which calculates how much an asset’s returns deviate from its average return over a period. A high standard deviation suggests greater uncertainty about future returns.
Volatility is not necessarily a bad thing, it simply reflects short-term price movements. A highly volatile asset can still deliver strong returns over time, but investors need to be comfortable with short-term fluctuations.
Investment Risk vs Volatility: The Key Difference
The key difference between investment risk and volatility is that volatility is a measure of short-term price fluctuations, whereas investment risk is the chance of permanently losing money or failing to meet financial goals.
An investment can be highly volatile but still offer strong long-term returns (e.g. stocks). On the other hand, a low-volatility investment like cash savings may feel safer but could expose investors to inflation risk, meaning their money loses value over time.
How Different Asset Classes Relate to Risk and Volatility
Different types of investments carry varying levels of risk and volatility.
Cash & Savings Accounts: Very low risk and low volatility, but subject to inflation risk.
Government Bonds: Generally low risk and low to moderate volatility, though interest rate changes can affect value.
Corporate Bonds: Higher risk than government bonds, but often lower volatility than stocks.
Equities (Shares): Higher risk and volatility, but with strong potential for long-term returns.
Property: Moderate risk and volatility, but values can be affected by market cycles.
Commodities (e.g., gold, oil): High risk and volatility, often influenced by external factors like geopolitics.
Key Takeaways
· Risk is about the possibility of permanent loss or failing to meet financial goals, while volatility is about short-term price movements.
· Low-risk investments tend to have lower volatility but may not provide high returns.
· High-risk investments can deliver strong returns over time but come with more volatility.
· A well-balanced portfolio considers both risk tolerance and investment time horizon.
Understanding the difference between risk and volatility can help investors make better decisions about their portfolios. Working with a financial adviser can help ensure your investment strategy aligns with your long-term objectives and comfort with market fluctuations.
Would you like to explore how to balance risk and reward in your investments? Get in touch, and we’d be happy to help.