Many investors want to know: How are volatility and risk related in an investment? Youve likely come across news about stocks flying to new highs or dropping to unprecedented lows. This rise and fall in investment values is known as volatility.
Volatility is completely normal in the stock and bond markets. But too much volatility can be a sign of risk. Its important to understand how much risk an investment presents so you know if its the right fit for your portfolio.
What is volatility?
In investing, volatility is a measure of how much an assets value changes over time. Because too much volatility can present risk, its important to understand how much volatility you can expect in your specific investments and in the market overall. Volatility is more important in the short term; it has less impact on long-term investments, like those for retirement.
While you cant completely avoid volatility — its built into the market — you can avoid buying stocks and other assets that are more volatile than the market overall.
What is risk?
According to the U.S. Securities and Exchange Commission Opens in new window (SEC), in finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. Investments in large, well-established companies typically carry less risk, while investments in newer startups and smaller companies carry more risk. However, as with most rules, there are exceptions.
Investing in riskier assets can pay off in a big way, as it offers you the chance to benefit from higher returns. However, risky assets are also more likely to lose value.
U.S. Treasury bonds are one of the lowest-risk investments you can find — but they also come with a low rate of return. While stocks are considered riskier than bonds, they generally give you a much better return.
Volatility vs. risk
Volatility and risk go hand in hand when youre deciding on an investment. Some of the most popular stock market metrics are used for both volatility and risk analysis.
Beta is a popular way to compare the volatility of an asset to the market. A beta of 1.0 means an assets volatility is equal to the markets — both are just as likely to rise or fall in value. A beta below 1.0 means an asset is less volatile than the market, while and a beta above 1.0 means its more volatile than the market.
A stock with a high beta (more volatile) is considered riskier; low-volatility stocks are usually less risky. Other popular measures of risk include alpha, r-squared and the Sharpe ratio.
Even so, volatility alone is rarely a reason to buy or sell. You have to look at the investment overall, including its risk, to make an educated decision.
In some cases, a longer investment time horizon can balance out the risk in a higher volatility portfolio. For example, if you have 10 years or more before you plan to tap your investments for retirement, you can ride out the markets ups and downs without too much worry. If you need those investments in the next year, however, you wont be able to wait for the market to recover from a drop.
Determine your ideal investment risk
Every investor has their own risk tolerance, or how much risk theyll accept. If you get a queasy feeling when the stock market goes up and down, you may be best suited for a low-risk portfolio. However, if you have lots of assets and can afford to take on more risk, you could be rewarded with better portfolio performance and higher investment profits.
So, how are volatility and risk related in an investment? While theyre not the same thing, they are closely related. Taking the time to understand your portfolios risk and volatility is vital to optimizing your investments for your needs.
What you can do next
If you choose and manage investments on your own, check your account and review the risk and volatility measures for each of your investments. If youre unsatisfied with or unsure of the results, consider investing through a professionally designed portfolio whose investment mix reflects your risk tolerance and time horizon.
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