This month Sam Dovey looks at two commonly used words in investing - risk and volatility – and explains the very important differences between them.
Risk. It’s a word that can put a lot of people off, especially if it’s used when referring to investing your hard-earned money. It’s also a word that is used interchangeably with volatility. In the world of investing, while connected, these words do mean very different things, as we explained in our podcast “Understanding volatility as part of the investment process”.
What does risk mean in investing?
Risk is fundamentally about the permanent loss of capital. It represents the possibility that an investor might not be able to recover their invested money, which is a scenario every investment manager aims to avoid. However, there are steps that can be taken to minimise risk when investing, such as having a robust, repeatable investment process.
What is volatility?
Volatility, on the other hand, refers to the fluctuations in the value of investments over time. Volatility is an inherent part of investing, indicating how much and how quickly the value of an investment can change.
Volatility is inevitable and, with the exception of perhaps cash, all asset classes come with some form of volatility. For instance, cash typically has lower volatility, while asset classes like fixed income or bonds can range from low to high volatility. In recent years, factors like interest rate hikes and inflation have introduced unusual volatility even in traditionally stable bonds, which have often acted as a ballast in portfolios.
Portfolio construction and navigating volatility
Effective portfolio construction is crucial in managing both risk and volatility. By understanding the volatility profile of each asset class, investment managers can build portfolios that aim to achieve a balanced risk-return profile. This involves diversifying investments across asset classes and being mindful of how different assets interact, especially during market shocks.
There are many different reasons people invest – it could be to generate an income stream, to provide inflation protection or for capital growth. Whatever the reason, we always encourage clients to make sure that their investment goals align with their risk tolerance and time horizon. Those investing over a longer time horizon, for example, may often have at least some exposure to equities, as more time in the market allows for some smoothing of any ups and downs. Conversely, for shorter time frames, investing in lower-risk assets can help reduce the impact of market fluctuations.
It’s also important to manage expectations regarding volatility. It's human nature that everybody wants to obtain the highest return over the shortest period of time and with minimal volatility. But unfortunately, this is particularly difficult if not impossible to achieve (and if it is achieved, it's probably more due to luck than a consistent, well considered process). It's unrealistic to expect high returns with minimal volatility; instead, investors should be prepared for some level of fluctuation in their investment values. Properly managing these expectations can help to avoid unnecessary worry during market downturns and allow one to stay focused on long-term goals.
In conclusion, there are key differences between risk and volatility. While risk is about avoiding permanent losses, volatility is about navigating the inevitable ups and downs of the market. If you’re looking to invest, make sure to consider your objectives, risk appetite and time horizon. A carefully constructed, suitable portfolio should help you achieve your financial goals while managing the market uncertainties.
If you’d like to find out more about investing with Ravenscroft, or if you have any questions you’d like us to answer, please contact us.
