When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
Risk vs volatility in investment: Types, comparative analysis & different asset classes
In the minds of many, ‘volatility’ is a scary word that evokes the fear of loss and high risk. That’s why we’ve written this guide for you to understand the relationship between volatility, risk and opportunity.
Jump into our comprehensive guide on how to navigate risky and volatile markets with confidence.
Jump into our comprehensive guide on how to navigate risky and volatile markets with confidence.
QUOTE
"The most important aspect of risk management is learning to think about long-term outcomes, not just immediate volatility. True investment wisdom lies in the recognition that risk and volatility are not synonymous."
Big ideas
- Risk pertains to the chance of an investment yielding a different outcome than expected, especially a loss, and volatility measures how much and how quickly the value of an investment changes over a period.
- The concept of a 60/40 portfolio is based on the balance of asset classes with different risk and volatility levels, typically 60% in higher volatility and return stocks and 40% in lower volatility bonds.
- Measures such as standard deviation, beta, and the Volatility Index (VIX) offer investors quantitative tools to gauge the risk and volatility of their investments, helping to tailor their portfolios to their specific risk tolerance.
Types of investing risks
In the financial markets, there is a need to understand the various types of risk in order to protect your financial well-being against unexpected changes that may shake up the markets. Now we’ll tackle the main ones case by case.
Risk type | Description |
Liquidity risk | The risk of not being able to quickly sell an investment at its fair market value. |
Market risk | The risk of investments losing value due to economic developments or other events that affect the entire market. |
Reinvestment | The risk of having to reinvest income or principal at a lower interest rate than the original investment. |
Credit risk | The risk that a borrower will default on a loan or a bond. |
Political risk | The risk of losing money due to changes in a country's political structure or policies. |
Business risk | The risk associated with the unique circumstances of a particular company that may affect its earnings. |
Legal risk | The risk of financial loss due to legal proceedings or contract disputes. |
Inflation risk | The risk that inflation will erode the purchasing power of money, potentially reducing the real value of investments. |
Interest rate risk | The risk that an investment's value will change due to a change in the absolute level of interest rates. |
Financial risk | The risk that a company will be unable to meet its financial obligations due to inadequate cash flow. |
It is good to be aware of all these risks but not all of them are easily assessed, or even if they can be assessed, not easy to guard against anyway.
Sometimes it might just be a matter of not investing in certain regions with higher political risk or avoiding currencies from countries with high inflation, etc.
Things like business risk in the stock market and credit risk in the bond market require vigilance on a more ongoing basis.
Sometimes it might just be a matter of not investing in certain regions with higher political risk or avoiding currencies from countries with high inflation, etc.
Things like business risk in the stock market and credit risk in the bond market require vigilance on a more ongoing basis.
Methods to assess and measure risk
Numerous tools and ways have been developed to help investors estimate risks that may arise from their investment decisions. Many of the types of risks mentioned above require ‘qualitative’ techniques, while with others, a ‘quantitative’ method can be used.
These are 5 of the best-known measurements for risk:
These are 5 of the best-known measurements for risk:
- Standard deviation
- Beta
- Value at risk (VaR)
- Sharpe ratio
- Stress testing and scenario analysis
To learn more about these risk measurement methods, including definitions and formulas, read our full guide on Principals and methods of measurement for investment risk management.
Metrics for measuring volatility
As you can see below, the methods for measuring volatility are different to those used to measure risk.
The following are four of the most popular for measuring risk in the stock market:
The following are four of the most popular for measuring risk in the stock market:
1. Historical volatility
This measure looks back at past market movements to gauge the degree of variability in an asset's price. It provides a retrospective view of volatility, helping investors understand how turbulent a market has been.
2. Implied volatility
Rooted in the pricing of options, implied volatility reflects the market's forecast of future volatility. It's derived from the prices of options and serves as a forward-looking indicator, capturing market expectations of price fluctuations.
3. Volatility index (VIX)
Often referred to as the "fear gauge," the VIX index measures the market's expectation of volatility over the coming 30 days, inferred from the prices of S&P 500 index options. It provides a snapshot of investor sentiment and expected market turbulence. Bond investors have their own version of the VIX known as the MOVe index.
4. Average true range (ATR)
This metric offers insight into market volatility by measuring the range between the highest and lowest prices of an asset over a given period. It helps in understanding the volatility of an asset in the context of its price range.
To get a complete grasp of the definition of volatility and how it works, make sure to read our complete Volatility Trading Guide.
To get a complete grasp of the definition of volatility and how it works, make sure to read our complete Volatility Trading Guide.
Risk vs volatility: Comparative analysis
Risk and volatility often get lumped together because volatile markets tend to be riskier to invest in. This makes intuitive sense because if the value of financial security moves up and down more, it is more likely that the investment experiences a bigger loss over the same timespan as another security that normally moves up and down less.
Differentiating between risk and volatility
Risk is about the possibility of an investment deviating from its expected outcome, especially resulting in a loss. It incorporates different aspects such as market risks, credit risks, liquidity risks and so forth; each of them presents threats to your investment capital.
Volatility measures the intensity and frequency with which price changes occur over time for any given asset. This statistical measure captures the extent to which returns vary without being directionally biassed. A highly volatile market indicates huge changes in prices whereas less fluctuations are associated with low volatility.
Volatility measures the intensity and frequency with which price changes occur over time for any given asset. This statistical measure captures the extent to which returns vary without being directionally biassed. A highly volatile market indicates huge changes in prices whereas less fluctuations are associated with low volatility.
Impact of risk and volatility on investment decision-making
Assessing Risk
You want to identify possible negative outcomes by analysing inherent risks associated with particular assets and find markets that appear to align with your own tolerance for risk.
In summary, this entails assessing each type of risk mentioned above using a simple investment analysis process:
In summary, this entails assessing each type of risk mentioned above using a simple investment analysis process:
For liquidity risk
- How easily can similar investments be bought or sold (market liquidity)?
- What is the trading volume? Low volume might make it difficult to sell.
- Are there any penalties or fees if you get out early or sell?
For market risk
- Review historical performance across various market conditions.
- Compare its performance against broad-based indicators like overall market indices.
Interested in learning more? Check out our S$P500 guide. - What is the nature of the economy at present? In addition, how much impact does this have on your investment?
For reinvestment risk
- What are the maturity terms for this particular investment? Also, what is the probability of gaining similar returns when reinvesting?
- How will interest rate trends concern future rates of return?
- To what extent can this investment adapt to a changing environment?
For credit risk
- Check the credit rating of the bond issuer or borrower.
- Research the financial stability of the issuer.
- Look at default rates for similar investments.
For political risk
- Consider the country’s stability that you are investing in.
- Evaluate how current and potential political events or policy changes could affect your investment.
For business risk
- Analyse the firm’s financial health, management, and industry position.
- Look at the company’s earnings history and projections.
- What is their competitive landscape? Similarly, have they undergone any regulatory changes?
For legal risk
- Have there been any legal cases involving this company?
- What countries have different laws that can affect the business in question?
- Can you find information on previous legal trouble with this firm?
Volatility management
Understanding and managing volatility helps investors in portfolio positioning, especially in terms of timing entries and exits, setting stop-loss levels, and selecting investment vehicles that match their volatility tolerance.
While some investors might view high volatility as an opportunity for significant gains, others may see it as a deterrent due to the potential for large fluctuations.
Choosing investments based on volatility levels involves a few practical steps:
While some investors might view high volatility as an opportunity for significant gains, others may see it as a deterrent due to the potential for large fluctuations.
Choosing investments based on volatility levels involves a few practical steps:
1. Define your volatility tolerance:
- How comfortable are you with big shifts in asset values?
- How long do you want to stay invested? Short-term investing may not allow for recovery from volatile downturns.
2. Use historical volatility measures
- Consider historical volatility statistics, often calculated using beta or standard deviation.
3. Analyse the volatility index (VIX):
- Monitoring the VIX offers insight into forward expectations regarding near-term market volatility. You can use this as an indicator of what investors feel about general market conditions.
4. Diversify your portfolio
- This allows you to use assets with different levels of volatility in a way that balances the risk level for the entire portfolio.
- For example, negative correlations can be used in a case where one asset has high volatility, and another asset has low volatility.
5. Use technical analysis
- With technical analysis, you may apply tools such as Bollinger Bands, which help graphically show the standard deviation from the average price.
6. Consider implied volatility in options
- When you use options, implied volatility will guide you on the market’s expectation of future asset volatility.
- The higher the implied volatility, the more price fluctuation is expected by the market.
7. Set stop-loss orders
- During unexpected spikes in volatility, stop-loss orders can act to limit losses.
- Trailing stop-loss orders are designed to let profits run while still allowing for some movement in an asset’s price.
Examples illustrating risk and volatility
Examples where high risk accompanies high volatility are numerous, so to better differentiate between these two concepts, it is perhaps more helpful to discuss scenarios where there is high volatility with low overall risk, as well as situations where there is low volatility but high overall risk.
High Volatility with Low Overall Risk
Day traders or those who trade volatile stocks may set tight stop-loss orders to minimise losses. While the assets they trade are highly volatile intraday, the overall risk is managed by limiting the amount of capital at risk in each trade.
Hedged Positions in Volatile Markets
An investor might buy a volatile commodity like oil but simultaneously hold a put option as insurance. The commodity's price could swing widely, but the put option hedges the investment, limiting the potential loss.
If an investor's portfolio mainly consists of conservative, stable investments but includes a small allocation to a volatile cryptocurrency, the portfolio experiences the volatility of the crypto asset, but the risk is diluted by the stability of the other investments.
If an investor's portfolio mainly consists of conservative, stable investments but includes a small allocation to a volatile cryptocurrency, the portfolio experiences the volatility of the crypto asset, but the risk is diluted by the stability of the other investments.
Low Volatility with High Overall Risk
An investor may have a large portion of their wealth in a single low-volatility bond or blue-chip stock. Despite low price fluctuations, the lack of diversification increases the risk if that particular asset class underperforms or the company faces an unexpected issue.
Holding long-term government bonds might show low volatility in the short term. However, if interest rates rise, the value of these bonds can drop significantly, presenting a high risk of capital loss if the investor needs to sell before maturity.
Certain assets like real estate or private equity can exhibit low volatility because they don’t have frequent price updates. However, the illiquidity presents a high risk since it can be difficult to sell the asset quickly without a significant loss if cash is needed urgently.
Holding long-term government bonds might show low volatility in the short term. However, if interest rates rise, the value of these bonds can drop significantly, presenting a high risk of capital loss if the investor needs to sell before maturity.
Certain assets like real estate or private equity can exhibit low volatility because they don’t have frequent price updates. However, the illiquidity presents a high risk since it can be difficult to sell the asset quickly without a significant loss if cash is needed urgently.
Risk vs. volatility in different asset classes
The overall level of risk of what you’re investing in is heavily influenced by the asset class as a whole. The entire concept of the 60/40 portfolio is based on the idea that 60% of your portfolio is in stocks that are more volatile with historically higher returns, while 40% is in bonds with lower volatility but not so high historic returns.
In the paper ‘Risk-Return Analysis’ by Dirk Schoenmaker & Willem Schramade, the following chart is produced to contrast the historical average returns versus the historical volatility of the major asset classes an investor would usually consider for their portfolio.
In the paper ‘Risk-Return Analysis’ by Dirk Schoenmaker & Willem Schramade, the following chart is produced to contrast the historical average returns versus the historical volatility of the major asset classes an investor would usually consider for their portfolio.
Source: Adapted from Berk and DeMarzo This table shows a general trend where higher historical volatility is associated with higher historical average returns, illustrating the risk-return trade-off inherent in investing. Treasury bills are typically considered low risk with lower returns, while small stocks are at the other end of the spectrum, with high risk and potentially higher returns.
Note that the S&P 500 index sits in the middle of the range, offering reasonable returns without too much volatility. This goes a long way to explain why index investing using ETFs has become such a popular investing strategy.
ETFs carry risks associated with their underlying assets; for instance, an ETF tracking a stock index will bear all the market risks involved with equities. However, they usually provide much less risk than individual stocks due to their diversified nature where investments are spread across various assets, sectors or geographies thereby mitigating poor performance from any given security.
The volatility of an ETF is closely tied to that of its underlying index or assets; typically broad-market ETFs following major indices like the FTSE 100 or S&P 500 display lower than average volatilities compared to single stocks due to benefits from diversification effect.
Nonetheless, niche and sector-specific ETFs like those focused on emerging markets or specific industries such as technology or biotech may be more volatile, reflecting the high risk and rapid change potential associated with these sectors.
Note that the S&P 500 index sits in the middle of the range, offering reasonable returns without too much volatility. This goes a long way to explain why index investing using ETFs has become such a popular investing strategy.
ETFs carry risks associated with their underlying assets; for instance, an ETF tracking a stock index will bear all the market risks involved with equities. However, they usually provide much less risk than individual stocks due to their diversified nature where investments are spread across various assets, sectors or geographies thereby mitigating poor performance from any given security.
The volatility of an ETF is closely tied to that of its underlying index or assets; typically broad-market ETFs following major indices like the FTSE 100 or S&P 500 display lower than average volatilities compared to single stocks due to benefits from diversification effect.
Nonetheless, niche and sector-specific ETFs like those focused on emerging markets or specific industries such as technology or biotech may be more volatile, reflecting the high risk and rapid change potential associated with these sectors.
Recap
Investment strategies benefit from distinguishing between risk and volatility, as the former involves the probability of an outcome differing from expectations, while the latter tracks price fluctuations.
Portfolio diversification across asset classes tempers the impact of market shifts, balancing higher-return, high-volatility stocks with more stable bonds. Quantitative tools like standard deviation, beta, and volatility indices are instrumental in measuring these factors, allowing for a strategic approach to aligning investments with risk tolerance and market behaviour.
Portfolio diversification across asset classes tempers the impact of market shifts, balancing higher-return, high-volatility stocks with more stable bonds. Quantitative tools like standard deviation, beta, and volatility indices are instrumental in measuring these factors, allowing for a strategic approach to aligning investments with risk tolerance and market behaviour.
FAQ
Q: How are volatility and risk related in an investment?
Volatility is a measure of how frequently and by how much a security price fluctuates. This contributes to overall risk, which is a broader term describing more than just price variance, which suggests different factors that might cause actual returns on investment to be different from what was expected.
Q: What is the difference between volatile and risky?
Volatile refers to how much the prices of investments fluctuate over specific time periods. On the other hand, risky means there is a possibility of losing money on an investment or generating returns far away from expectations.
Q: Does high volatility mean high risk?
Although one could argue that higher volatility represents higher levels of risk, there are some instances, such as for short-term traders, where it doesn’t necessarily follow that there will be a greater risk of loss over the long run when they are trading a volatile short-term fluctuation in price.
Q: Why is volatility not a good measure of risk?
Volatility is not an all-encompassing gauge of risk and uncertainty as it only accounts for the range of price differences and not the probability of underperformance or even the actual loss itself. Risk takes into account a wider range of considerations, such as credit risk, liquidity risk and market risk that volatility does not cover.
