The difference between risk and volatility

Published: March 22, 2016 at 11:16 am

Risk represents the probability of loss and volatility a measure of fluctuation. The loss here refers to a loss of capital and fluctuation the ups and downs in the movement of an asset. Now these are textbook definitions. When applied to real-life new dimensions get added on, as with everything else.

Let us start with the standard refrain of the mutual fund industry: risk is not volatility.

Everyday ups and downs of the stock market is volatility. They do not represent risk/real losses (or gains!) unless redeemed.

The biggest risk is to blindly believe that risk is not volatility!

The volatility of the stock market can be measured in multiple ways. The simplest is perhaps the difference the maximum return and the minimum return.

Sensex-total-returns
Min and max returns are averages for every possible investment duration between 1979 and 2013

Will equity markets give ‘good returns’ over the next 5 years? One look at the above graph will tell you that the volatility over 5 years is pretty high. If I go ahead and take a chance, volatility represents risk.

It is only over very long durations, volatility is small enough to not represent risk. Read more: Equity investing: How to define ‘long-term’ and ‘short-term’

Even for a long-term goal after a few years, volatility represents risk. Suppose you have financial goal 25 years away. Today, volatility does not matter to you. However, 20 years later, volatility represents risk. Which is why it is crucial to exit equity when the goal nears.

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Risk is not volatility only when you don’t have to redeem in the near future. However, as pointed out by Krishna Kumar at AIFW, this applies to only normals ups and downs of the stock market. If there is a 40% crash tomorrow, then recovery may take several years. If I don’t know how to assess the impact of such an even on my financial goals, knowledge of volatility metrics means little.

Volatility is mathematical. Risk maybe psychological and if so, often due to innumeracy.

Taking comfort in past performance, having blind faith that an SIP will work, or that equity will beat inflation over the long term are examples innumeracy risk. There is no mathematical evidence to back that.

Other examples: Taking comfort in fixed income, not understanding what a real return is; Assuming cost inflation index represents real inflation.

Use of volatility models without understanding inherent limitations also represents risk! Read more:Value at risk (VAR): Would you buy a car with a faulty airbag!

There are other types of investment risks which have little to do with the volatility of an asset class. A nice compilation can be found here

 

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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com

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4 Comments

  1. Volatility is a form of risk but is not the only risk that investors have to deal with. The other risks include falling short of your goals, default risk, interest rate risk, hyperinflation and changes in taxation (peculiar to India). When planning for the long term one has to factor in all these risks.

  2. Volatility is mathematical. Risk maybe psychological and if so, often due to innumeracy.- very well said , sums up the whole concept

  3. When I read about rolling returns on freefincal.com, I couldn’t grasp the concept. After reading lot of your posts with or without or partial understanding, I am getting the picture. Explaining risk-volatility with average minimum, maximum returns of every possible investment duration helps a lot now. sensible tool. Helps to ladder up to learn more complicated things for beginners like me.

    Thank you and love you pattu sir for your genuine efforts without expecting any benefit and reward. I like to thank your loved ones, family

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