The Common Sense Investor

Understanding the difference between risk and volatility is the key to investment success.

When it comes to making and attempting to grow your investments what is your attitude towards the inherent investment risk involved? What about its volatility?

These are questions that the common sense investor should ask himself at some point. The good investor understands the difference between risk and volatility and uses it to his advantage. Those who do not make the distinction between volatility and risk are more likely to make serious investment mistakes. There is an illusion of safety in less-volatile but lower-return stocks with the view that these stocks are less risky. But, it often turns out they aren’t less risky; they are just less volatile. Knowing this difference can enable you to attain the holy-grail of investing: high-returns with low-risk.

But first, let us qualify and define the terms we are using.

Risk means at least three different things depending on who you talk to: a professional financial expert or stockbroker, a beginning investor and the common sense investor.

Most people define risk as the possibility of losing principle. Many financial planners have come to conflate risk with volatility in price. By their definition, securities or investments whose prices fluctuate the most in a short period of time are considered the riskiest while those whose prices hardly moved (like certificates of deposit) are thought of as the safest. But for the common sense investor, the correct definition of risk is the probability of losing purchasing power because it takes into consideration other factors like inflation. This last definition is more descriptive and indicative of economic and market forces.

Volatility, on the other hand, has been defined as a measurement of the change in price (otherwise known as fluctuations) over a given period of time. Volatility has usually been expressed in terms of percentage and computed as the annualised standard deviation of the change in percentage of the daily price.

Unfortunately, the terms risk and volatility, though they mean two different things, have been erroneously lumped together. Most people have come to think that risk and volatility are two interchangeable terms when they have two vastly different definitions. Wall Street itself is to blame for this misunderstanding because many of its stockbroker experts as well as some people from the academia began calling volatility “risk†as a way to simplify terms for the public.

This mistake is costing many people money because, by confusing the terms and, with investors propagating it further by talking of volatility risk as the only risk, and thus making investors scramble to limit the volatility in their portfolios without really thinking of the underlying assumptions.

For example, many fund managers urge investments in bonds or cash, despite poor returns just because they fluctuate less than stock prices. Sure, in the short term, such investment types with low-volatility are less risky but over the long term they may be more risky when measured against prospects for long-term growth.

As a conscientious investor, you must know the proper definitions that are being used in order to make valid conclusions and safe decisions. Having the right information will enable you to answer the previously posed question with confidence and foresight.

The common sense investor should aim for investments with consistently high returns despite short-term volatility. By ignoring short-term volatility and instead looking for good companies at reasonable prices, you’ll save thousands of dollars over your investing lifetime.