Last Updated on December 29, 2021 at 11:53 am
In this post, I discuss the difference between risk and volatility. Distinguishing the two can lead to better money management. Please do not expect the usual sales guys argument that volatility is good and everything will turn out okay in the long term. So let us start with the basics.
This post is part of Resolve – a series of steps on the basics of investing and portfolio management.
- Step1: How to quickly select equity mutual funds and build a diversified portfolio
- Step 2: How to Quickly Decide: Should I stay invested or exit my mutual fund?
- Step 3: Do we need to time the market?
- Step 4: Why we need to gradually pull out of equity investments well before we need the money!
- Step 5: How much equity should I hold in my portfolio?
- Step 6: Forget tax and exit loads, this is why your portfolio should be rebalanced each year
- Step 7: this post.
What is risk?
Suppose we want something in life, the chance that we do not get it or get something less desired is a risk. The financial services industry likes to portray risk as the chance of losing money but it is a lot stronger than that. For example, you will see articles about how SIPs “in the long run” never gave negative returns or made a loss.
This is stupid. If I run a SIP in an equity fund for years and years and get 0% return is the risk absent? Investment risk is the chance that we get a return or a corpus lower than what is desired or needed.
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What is volatility?
Volatility is the up and down movement of any product can be traded freely in the capital market.
What is the difference between risk and volatility?
Risk has many shades. Volatility is one of them. So all Volatility is risk.
Now don’t fool your self into believing daily volatility will only to notional losses and is not a risk. Volatility is notional only when you are not invested in a fund or a stock or a bond. The moment you put money in there, the volatility becomes risk – your risk. Short term or long term does not matter.
Is this – yesterdays (21-9-2018) Sensex movement – volatility or risk?
If you saw it in real-time, it is risk. If you see it now, it looks like volatility. The fact is no one who saw it fall would have believed that it would recover that fast. Anyone who says volatility does not represent risk to the investor is either selling products or has been brainwashed by media articles from people who sell products or is in general suffering from hindsight bias. During times likes this the biggest risk and the biggest noise comes from being in the Facebook Group Asan Ideas for Wealth.
Hot hand fallacy You would be surprised by the number of people who believe
(1) equity will give good returns in the long term so this daily volatility does not matter and I am going to be 100% in equity for long-term goals
(2) Why should I plan for retirement? I want to work forever
(3) Why should I buy health insurance? I will collect enough money to handle old age hospitalization.
All these are examples of the hot-hand fallacy Things are looking good now. So they will always look good forever. Things turned out okay in the past. So they will turn out okay in future too. Old people get sick more than young people, so nothing will happen to me until I turn old.
So volatility is a type of visible risk. Meaning there are other types of visible and invisible risks. If you want to disregard volatility as resulting in “only” notional losses, then be mature enough to disregard notional gains too. Don’t act smug about how much returns you have made so far, about how your investment decisions turned out okay before they actually have.
Types of visible and invisible risks
This is a vast topic with books written about them. So I will only list a few examples that we encounter every day.
1: Credit rating is a visible risk: BB is riskier then AAA. A sudden change in credit rating (or credit risk) is an invisible risk (you don’t know until it hits you)
2: Fluctuations in the price of a bond that is part of a debt fund is visible (interest rate) risk. A gradual lowering of interest rates when bonds of FD mature and renewed is an invisible or less visible risk. This is also known as reinvestment risk.
3: Daily change in the price of commodities that we use is visible (inflation) risk. The impact of inflation after retirement is an invisible risk (when we are young).
4: Associated with inflation risk is longevity risk. Running out of money in retirement or expenses exceeding pension. This is an invisible risk before retirement and visible after.
4: The trouble that we can spot in a balance sheet is a visible risk. The fudging up done (if any) to beautify a balance sheet is an invisible risk.
5: The difficulty in making a clean transparent real estate transaction is a visible risk. The perceived return from a property before it is put out on the market is an invisible risk. Difficulty in buying a property at a price that it is actually worth is a visible risk. Difficulty in selling a property at a price that it is actually worth is an invisible risk. This is also known as liquidity risk
6: When a single stock or bond boosts returns it is concentration risk and is often invisible.
7: Currency risk is when the exchange rate becomes unfavourable rather suddenly. This is a visible risk but is often unexpected. Current risk can trigger interest rate risk in bonds leading to a crash (July 2013), it can trigger inflation risk and higher stock market volatility
8: Extreme event risk; War, Earthquakes, floods etc that affect all spheres of life. Cannot plan for this and it is almost always unexpected
9: Poor governance risk This leads to scams and subsequent bailouts. Often the elephant in the room that people choose not to see and complain only after it defecates. This is visible to those responsible and invisible to outsiders.
10: Sudden change in government policy. Eg. announcing that EPF will be taxed (and then rolled back in fear). Announcing that equity will be taxed and so on. This is an unexpected risk and unless we are pessimists cannot be planned for ahead.
This is a much more comprehensive list of investment risks
Resolve – a series of steps on the basics of investing and portfolio management.
- Step1: How to quickly select equity mutual funds and build a diversified portfolio
- Step 2: How to Quickly Decide: Should I stay invested or exit my mutual fund?
- Step 3: Do we need to time the market?
- Step 4: Why we need to gradually pull out of equity investments well before we need the money!
- Step 5: How much equity should I hold in my portfolio?
- Step 6: Forget tax and exit loads, this is why your portfolio should be rebalanced each year
- Step 7: this post.
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