NEW YORK (TheStreet) -- As investors, we usually confuse volatility with risk, and by conflating the two we end up incurring significant costs in our portfolio. While there may be many external factors affecting a stock price movement, it is crucial for investors not to use volatility as a proxy for risk. A clear distinction between the two can help investors make prudent investment decisions and ensure that no beneficial opportunity is missed or no huge losses are incurred.
As Berkshire Hathaway (BRK.A - Get Report) (BRK.B - Get Report) CEO Warren Buffett mentioned in his annual letter to his shareholders, "Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray."
What Do Theorists Say About Volatility and Risk?
Interestingly, modern portfolio theorists treat both volatility and risk the same way. According to Investopedia, "volatility refers to the amount of uncertainty or risk about the size of changes in a security's value." A typical statistical measure of volatility of a fund is captured through standard deviation of returns. Theoretically speaking, it is considered to be an accurate measure, but practically its unrealistic assumptions make it more complex and sometimes unreliable. It fails to take extreme events into consideration.
Another measure that is commonly used is Beta, which compares the movement of risk (or volatility) of a certain fund with an index or a benchmark. But the statistical measure does not include new information or recent developments. For long-term investors, beta fails during short-term volatility, as it is unreliable with little information to predict the associated risks in the future. In either of the statistical measures, volatility is defined as risk and does not reflect the likelihood of any gains.
How to Spot the Difference Between Volatility and Risk
Volatility is an inevitable by-product of investing in a financial market while risk, on the other hand, relates to the possibility of a permanent loss of investments in financial markets.
Risk occurs when return on a certain stock or portfolio is different from the expected returns. It can reap huge benefits (when actual return is higher than the expected) or lead to large losses. Traditional finance theory treats both gains and losses as risks. But, according to behavioral finance, risks are more often related to losses or negative events, while gains (when one gets more than expected) are mostly looked at as huge payoffs. Investors tend to react to a higher degree in case of huge losses, than in case of substantial gains. Hence, risk in finance is looked at as a permanent loss of capital and probability of losing money. Typically it means being forced to sell when one does not want to.
According to an interview given to Bloomberg, Oaktree Capital's Howard Marks pointed out "while volatility is quantifiable and machinable... it falls far short as 'the' definition of investment risk." He further added that investors are worried of risk because of fear of a permanent loss.
Many modern risk models have been developed to keep investors away from facing huge losses (and in many cases they could be accurate) but during high market volatility they do not work too well. Most fail to capture the investors' fears, sudden shocks and uncertainty that can create frequent fluctuations in the markets.
Market Panic due to Volatility can lead to Risks
Markets have no rulebooks on perfect investing and theory does not differentiate between volatility and risk. In the practical world, volatility should be looked at as a good thing to seek out rather than a bad thing to avoid.
While diversification helps in minimizing risk, it is difficult for any portfolio to remain volatility-free. Risk has and will always be looked at as a permanent loss of capital. An investor can meet financial goals during volatility but risk occurs when the goals are not met. Conclusively, the biggest risk faced by any investor is panicky market reaction due to high volatility in markets.
By confusing volatility with risk, the investors tend to get fearful about a harmless temporary volatility and can often ignore the risks as a potential buying opportunity.
Here are three things you should know about volatility and risk that will help you make better investment decisions:
1. Less volatile stocks can mean risk too
Macroeconomic factors may make risk-free bonds (considered to be less volatile) risky if the country faces adverse situations like a default on its debt payments and the investor chooses to act during that risk event. In such case a "safe" part of a portfolio can look riskier than its counterparts. Even though such an occurrence may happen only once a year, it could still lead to huge losses that may affect the long-term goal of an investor's portfolio. High volatility of a stock does not necessarily mean it is of high risk. A highly volatile stock may be less risky than a lesser volatile stock.
According MarketWatch, a paper by Bank of International Settlements points out that low volatility could be a sign of high-risk taking over a given period of time. Had volatility and risk been synonymous to each other, low volatility would mean lower risk.
According to Warren Buffett, "The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities -- Treasuries, for example -- whose values have been tied to American currency."
2. Volatility and Risk are confused during market fluctuations
In reality, volatility of a stock or a bond may not equate with its risk. Frequent fluctuations may make one believe that there is risk associated with a certain stock but the real picture might be quite the contrary. When a stock is volatile, it tends to make big moves (upwards or downwards) but when a stock is risky, it means that it can lead to losses.
In reality, people do no look at profits as risk. A stock that never goes down may be risky for a short seller but a stock that always goes down would be at zero risk. But, volatility remains the same for all, regardless of direction, regardless of holding a long or short position. Volatility is inevitable and price fluctuations (low or high) are bound to happen in the market.
Volatility and risk are confused during major market fluctuations. Frantic buy and sell reactions can lead to overtly changing positions in a certain stock that could have reaped good returns in the long term. For short-term investors, reaction to volatility could be very different than a long-term investor. Short-term portfolios are not created with long-term investments in mind and are designed to be convertible to cash quickly and with ease. Responses to volatility are of importance for short-term investors since they are in the markets for quick gains.
3. Volatility could be a 'type of risk' but not all risks arise from volatility
Quite often, market swings can lead to instant reactions among long-term investors and influence long-term investment decisions. The longer the investment time horizon, the less is the effect of volatility on our long-term investment goals. While minimizing volatility may hurt returns over a period of time, the same may not hold true for risk. Minimizing risk will be beneficial to both long and short-term investors.
To evade all risk is not only difficult but also impossible. While common investment tactics like diversification can surely minimize the risk, forecasting it to perfection may never work during every market scenario. Volatility could be a "part" of risk but is not risk. Risk can be reflected through fundamentals like competitive advantages, market share, debt, size, regulation, monetary policies, and nature of markets. Volatility could be a measure of one type of risk and could be looked at as "short-term threats and longer-term opportunities."