Risk and volatility are not the same thing

Are volatility and risk the same thing?

Many people, including financial professionals, use the terms risk and volatility as though they were interchangeable. In fact, they describe two very different things, and confusing them can lead investors into serious mistakes. Understanding the distinction is one of the most valuable pieces of knowledge any investor can have.

In this video, financial writer and podcaster Carl Richards explains the difference. Risk, properly understood, refers to a permanent loss of capital. Volatility, by contrast, is short term by nature and a relatively common occurrence in markets. As long as you stay disciplined during volatile periods, they shouldn't pose any long-term risk at all.

You'll learn that volatility is really just a measurement of standard deviation, or, as Richards puts it more plainly, how much something wiggles. Stocks wiggle more than bonds, and bonds wiggle more than cash. The question is simply whether you can handle that movement. He also points out that there are plenty of techniques for ignoring it, and that if you're not paying constant attention to short-term fluctuations, you don't have to deal with them at all.

Richards is candid, too, about the language problem. The industry, including genuinely good advisers and planners, throws around words like risk and volatility while assuming everyone understands them. Most people don't, and there's no shame in that. Which is why he offers a valuable piece of advice for anyone working with an adviser: you should feel completely comfortable saying, "Hold on, could you back up and explain that?" Any good adviser will welcome the question, and if they don't, find another one.

The takeaway: don't confuse risk with volatility. Volatility feels frightening in the short term but poses little threat over the long run, whereas genuine risk means losing your capital permanently. Understanding that distinction, and never being afraid to ask your adviser to clarify anything you don't understand, will make you a calmer and more successful investor.

Chapters / Key points

• Why risk and volatility are so often confused
• Why even good advisers assume clients understand the terms
• What risk actually means: permanent loss of capital
• What volatility means and why it's short term
• Volatility explained as standard deviation, or "how much something wiggles"
• Why stocks, bonds and cash wiggle differently
• Why discipline turns volatility into a non-issue
• Techniques for ignoring short-term fluctuations
• Why you should always ask your adviser to clarify

Transcript

Risk and volatility are not the same thing

Robin Powell: Many people, including financial professionals, use the terms risk and volatility as if they were interchangeable. In fact, they're two very different things. Here's the financial writer and podcaster Carl Richards.

Carl Richards: Often, we use words like risk and volatility and we assume, the industry, even really good financial advisers and financial planners will use words like risk and volatility and assume that everybody knows what it means. I know I wouldn't if I was not in this industry, there is no way. If I took a statistics class in college, I wanted to forget it as soon as possible. Most of us don't know what that means.

Robin Powell: Risk specifically refers to a permanent loss of capital. Market volatility, on the other hand, is by its nature short term, and a relatively common occurrence. As long as you stay disciplined during periods of volatility, they shouldn't pose a long-term risk at all.

Carl Richards: You view volatility as really scary and risky in the short term, but not risky in the long term. And so, volatility is really, underneath, just a measurement of standard deviation. What that means is, "How much does something wiggle?" That's all it means. Stocks wiggle more than bonds, bonds wiggle more than cash. You've just got to decide if you can handle that. Now, there's a whole bunch of tricks and techniques you can do to ignore it. Right, if you're not paying attention to it, you don't have to deal with it. So, that may be a hint.

Robin Powell: The distinction between risk and volatility is a very important concept for investors to understand. If you're in any doubt about it, you should see a financial adviser.

Carl Richards: As a client of an adviser, the one thing I think you should feel absolutely sure that you can do is to say, "Hold on, could you back up and explain that?" Just ask clarifying questions. Any good adviser will appreciate it, and if they don't appreciate it, find a different one.

Robin Powell: So, don't confuse risk with volatility. And never be afraid of asking your adviser to clarify anything you don't understand.