So far this month, we have talked about the purchasing power of money and how to invest for the long term so that your emotions and the “never-recommended” urge to time the market don’t erode that power when you need your money the most - at retirement. This week, I want to revisit the subject of risk and volatility. If you have taken my retirement course, you will remember that we talk about this quite a bit, particularly because they are different. We don’t have a choice about how and when the markets become volatile, but we do have a choice about the risk we take in our own portfolios. Let’s start with risk.
So, what is risk? Risk is the chance that an investment's gains will differ from what we expect them to be. This means that when you invest, you are taking the risk that you may lose some or all of the principal amount you’ve invested. Like everything economic and market-related, risk doesn’t come with a handy crystal ball, so we use history to show us an investment’s behavior pattern patterns when making investment decisions, among other things.
The fact is that we are all exposed to some kind of risk every day just stepping foot out the door. And, since you likely do this every day, you know that some days you encounter risk and others don’t. But here’s the thing, each investor has a different tolerance for risk, which means that not all investors take on the same level of risk. Your risk level is determined by your personality type, lifestyle, time horizon, and age, to name a few factors. Your personality and your tolerance for risk are really important here. If you are likely to be skittish with volatility, you may be one of those folks we talked about last week who tends to cut and run when the market gets bumpy. On the other hand, if you aren’t someone who hangs on the media’s every work and isn’t tempted to check the value of your portfolio every day, then you are likely more comfortable with a little risk. So, what is the point of that?
Well, with risk may come reward, so the riskier an asset you invest in, the more reward you’ll seek for agreeing to take on that risk. This brings us to the fundamental relationship between risk and return. Let’s look at an example. Say you are thinking of purchasing a bond. You are comparing a US Treasury Bond, often considered a safer investment, with a corporate bond. The Treasury bond provides a lower rate of return than the corporate bond, but if you are willing to take on the risk of a corporation going bankrupt, the corporate bond offers a higher rate of return.
Ultimately, how much risk you take on is within your control, and you should spend a great deal of time discussing initially with your advisor. One of the most important hats an advisor wears is that of a behavioral coach. We are here to help you understand your goals, timeline, needs, and your risk tolerance so that we can help your money achieve what you need it to do. To do that well, we need to help you understand your own tolerance for risk and the importance of staying in the market for the long term. And yes, we are here to talk you out of that tree in the yard when the markets are dishing out gale-force winds.
Now that we have covered risk, what is volatility? Volatility can be described as how rapidly or severely the price of an investment may change. In contrast, risk can be described as the probability that an investment will permanently lose capital.
When it comes to investing, risk and return go hand in hand. Investors get rewarded for taking risks, but sometimes those risks result in losses. Losses can be permanent or temporary. Volatility is commonly used as a substitute for risk, but it is just one risk investors can face.
Volatility refers to the amount an asset’s price or value goes up and down. Volatility changes over time. These changes are generally gradual. Since no one has figured out a way to predict the future, we use historical volatility to indicate the likelihood of future volatility.
Liquidity is one type of risk investors may find themselves grappling with, but just because your investments are liquid does not mean that their values are stable. This is where volatility can threaten your wealth because investments are moving targets.
In order to keep your head on straight during tough times, it helps to separate risk from volatility. They are not the same thing. Volatility in investing is often temporary, but it can bleed into risk if you do not know yourself as an investor. This is because market volatility can become emotional. When you bring your emotions to the investment table, you become your biggest risk. Fortunately, there are ways to prepare and protect both you and your portfolio from emotions, risk, and volatility, and we will talk about those investing basics next week. However, there is no better way to protect yourself from emotions than working with a financial advisor who understands the behavioral risks of his or her clients. Remember, the reason you use an advisor is to have a coach to help you manage your money, but you are the most important factor in the success of your investments.
Until next time…
One last thought, I believe an educated investor is an empowered investor. If you like what you’ve read and think your friends and family can benefit as well, please share.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested in directly.
All investing involves risk, including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Dollar-cost averaging involves continuous investment in securities regardless of fluctuation in the price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.