Basics: What is the difference between risk and volatility?

Published: March 11, 2022 at 6:00 am

In this article, we discuss the difference between risk and volatility and why one must not misinterpret the difference!

What is risk? Risk can be defined as any factor that can result in a loss of value. For example, if you buy something for Rs. 10 and after a year its market value is Rs. 25. A month later its market value has decreased to Rs. 22 is an example of risk. Risk is the possibility of value erosion with or without loss of principal.

There are many factors that can result in a change in the value of an asset and each of them is usually classified as a type of risk. Some factors result in daily price changes and some occasional price changes. Some factors are market-linked and some are not. Many of these factors work both ways. That is, they increase asset value sometimes and decrease it sometimes. So risk is a double-edged sword.

Some risks are visible daily and some appear to strike suddenly. Thus most often, risk results from a lack of anticipation. Let us understand these statements with examples.

1 Default risk or credit risk: This is the risk of the borrower not paying back the principal and/or defaulting on interest payments. The way this risk manifests on a daily basis is complex.


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  • Market-linked credit risk: Suppose a bond is rated AAA on its issue.  After a few months, rating agencies downgrade it to AA. Then the price of the bond will fall. If the rating is restored to AAA later, the price will increase. There has not been an actual default but a mere change in credit rating has resulted in occasional price changes.
  • Non-market linked: Suppose you buy the same bond with the intention of holding it until maturity. Until there is an actual delay in interest rate payment or the possibility of non-payment of principal, changes in credit rating will not affect you.
  • Another example of non-market linked credit risk: Suppose RBI suspends the banking licence of your bank. You will only get back Rs. 5 lakh and it also depends on how soon you get that money back.
  • These are examples of invisible risk. Before the credit agency or regulator makes the announcement, not much is known about the health of the borrower to the typical retail investor.

2 Reinvestment risk: Suppose you buy and hold a bond or fixed deposit until maturity for 8%. When the amount matures and you wish to reinvest, the interest rates are down to 6% you are forced to earn less. This is inevitable in a developing economy.

  • Market-linked reinvestment risk: A few years ago, liquid fund returns were 9% a year. Many investors in FB group Asan Ideas for Wealth looked at this and assumed they will also get the same. Interest rates dropped and newer bonds had lower coupon rates. So gradually liquid fund returns started decreasing. This is also an example of past performance risk.

3 Redemption risk: When too many people try to redeem from a bank (aka bank run) or from a mutual fund holding illiquid assets, the NAV of the fund will drop. Recall in the movie the big short, redemptions were stopped from Michael Burry’s fund. Franklin closed down six of its schemes because of this.

I mentioned above, risk results from a lack of anticipation. The Franklin episode was such an instance for me. While I anticipated credit risk in their funds, I did not anticipate redemption risk although we had one such example of redemption risk in 2008.

4 Interest rate risk:  Those holding bonds will feel the pain when newer bonds of higher coupon rates are issued. This also impacts the bond market but the speculation of rate change usually plays a bigger role in impacting bond prices and debt fund NAVs unless there is an unexpected event like in July 2013 when the overnight rate increased by 2% resulting in a “bond crash”.

Similarly, there are other types of risk like currency risk, geographic risk (eg. if someone held investments in Ukraine or Russia now), inflation risk etc.

What is volatility? Volatility is one way to measure the extent of visible risk. It is a measure of price fluctuations of an asset, stock, index or mutual fund NAV. The standard deviation is used to represent volatility and gives us an idea of much prices fluctuate.

Visible risk here means frequently occurring risk. A crash in the debt fund NAV due to a bond default is not a daily occurring risk  (hopefully!). It must be kept in mind that such occasional risks can adversely affect the volatility measure and care must be taken to use volatility with context.

Typically the standard deviation uses daily or weekly or monthly absolute returns. It is defined as the average deviation of each return from the average return. The higher the value, the higher the price fluctuations.

Volatility tells you how much the price fluctuates relative to some asset class like a liquid fund or overnight fund that does not fluctuate much. However, volatility does not tell you the cause of the visible risk.

That visible risk can be due to any of the above-mentioned risks: credit rating changes, speculation on interest rate movements, speculation on currency supply vs demand, inflationary pressures etc. It must be understood that price movements occur due to speculation of a good or bad event and the actual event itself or some other sudden unexpected event.

Some of you may think is not the underlying cause (risk) more important than the extent of fluctuations (volatility). Not quite. The visible risks mentioned above affect the asset price at the same time on a daily basis. So it is hard to identify individual risks. Moreover, you can only identify the risk or fluctuation after it has occurred. So it cannot provide your specific guidance about the future, only generic advice (which for most is more than enough!).

To summarise, risk is any factor that results in a change in the value of an investment. Volatility is one way to measure the extent of frequently occurring (visible) risks without identifying the source of the risk. Drawdowns, downside capture, Ulcer index are some other visible risk measures.

How risk  ≠ volatility is misinterpreted (often conveniently)

So risk is not the same as volatility in the same way as obesity is not the same as a BMI (BMI is one way to measure the extent of obesity but the underlying cause of obesity requires further investigation).

This does not mean volatility is not important! Many people argue that volatility is day-to-day price fluctuations and is not important for making returns from equity over the long run. As one may expect these are either product sellers or product manufacturers.

What we fail to recognise is, when the price of an asset class fluctuates, its return also fluctuates. So when we say the volatility of an asset is high, it means its return can fluctuate wildly. See: Stock market always moves up in the long term but returns move up and down! And Do not expect returns from mutual fund SIPs! Do this instead!

Why the price fluctuates is an interesting study especially if we are going to be given a degree for it. But in the real world, we need to make some money and for this, we need to understand the extent of volatility more than the cause of the volatility!

 

A young reader recently wrote to me saying, “why to bother about day to price fluctuations! If we buy good companies we are likely to make money over the long term”. Spot the risk in this statement!

So the point is, the extent of volatility in our investments tell us how much actual returns can fluctuate above and below our expected returns and is extremely important! So too are the invisible or infrequent risks that do not show in the volatility!

I hate to be the one to break it to you but there is zero evidence that long term systematic investing in equity will give you a good return over the long term or we will get a return close to what we expect.

The only evidence available is there is a reasonable chance that equity will beat inflation over the long term. See: Why should I invest in equity mutual funds when there is no guarantee of returns?

These two are not the same! After 15Y, 8% = inflation-beating return (it is even today!!) Sitting and hoping for a 12% return and getting 8% from equity after 15Y is = failure. See: Equity may beat inflation but that doesn’t mean you will!

Expecting less and trying to invest more than necessary is essential. In addition, every year the asset allocation and return expectation should be evaluated with a specific goal in mind. We need to appreciate both volatility and risks to avoid slip-ups in our investment journey.

To get started the right way, you can consider watching this seminar: Basics of portfolio construction: A guide for beginners

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Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over nine years of experience publishing news analysis, research and financial product development. Connect with him via Twitter or Linkedin or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation for promoting unbiased, commission-free investment advice.
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