With investing, it's common to confuse risk with volatility.
Risk, in general, is exposure to danger. Regarding investing, let's take risk to mean the probability that an investment will not achieve an expected return in a given time period.
Volatility is a statistical measure of the dispersion of returns for a given investment. It can be measured the standard deviation of returns from long term rate of return for the asset. Simply, volatility is a measure of how much the price of an investment swings in the short term compared to the long term rate of change of that investment.
Investors, people on the internet, and even some financial advisors believe that high volatility equals high risk. I would argue that is not the case.
Volatility equals risk when an investor's time horizon is short. If you plan to buy a stock and hold it for 3 months, 1 week, or 1 day, then a highly volatile stock has a higher probability of changing price, either up or down, than a non-volatile stock whose short term rate of change seldom deviates from it's long term rate of change. So if your time horizon is short, a volatile investment is a risky investment.
When volatility ≠ risk
If volatility is a how much an investment fluctuates in the short term compared to the long term, then it follows that the chance of the value of an investment deviating from the long term rate of change of that investment decreases with time. And if risk is the probability that an investment will not achieve an expected return in a given time period, then risk from a volatile investment decreases with time.
If an investor has a long time horizon, volatility does not equal risk. There are volatile investments that are low risk. There are also non-volatile (stable) investments that are high risk.
It's important to understand why an investment is volatile in the first place. It could be volatile because it's highly speculative, like cryptocurrency. It could have a high degree of risk, as in a biotech company that develops a novel procedure that can cure a widespread disease but is contingent upon FDA approval. A stock could be volatile because it has a world changing technology that has yet to be proven profitable (see Tesla). It could be volatile simply due to hype and current popularity leading to high trading volumes in either direction despite the company having a sound product, income statement, and balance sheet (see Zoom). If a company is new and is focused on building a long term business rather than pleasing shareholders with quarterly profits, it could be volatile because investors don't know what time horizon to value it with (see Appian). Or it could be volatile because of bad actors generating buzz on Reddit leading to trading chaos and short-squeezes and the stock price becoming completely detached from value of the underlying business (see GameStop).
When determining the long term risk of a volatile investment, you must determine the cause of the volatility. In general, faster growing companies have more volatile stock prices – mostly due to investor excitement. However, volatility alone is NOT an indicator of a good investment or a bad one. And volatility is NOT a measure of risk in the long run.
Key investing principle: Recognize that which does not matter.
This chart shows the long term returns of a volatile vs non-volatile investment.
This chart shows that same volatile investment's stock price compared to the underlying value of the company.
Notice a few things about the two charts above. In the short term, the volatile investment is risky. That is, the returns are highly unpredictable. It's as if you gave computers and millions of dollars to monkeys in suits and said "go outsmart each other this week." Also notice how in the long run, the stock price tracks the underlying value of the business. There are periods of steep overvaluation followed by bargain prices, but the price trends towards the value of the underlying business.
This chart simply shows how volatility is not an indicator of long term performance, and stable investments are not necessarily low risk. You can slowly and steadily lose money investing in "conservative," "stable," stocks if you believe that by avoiding volatility you avoid risk.
In the chart above, the green line is the investor who invests in innovative companies based on an understanding of business models, products, leadership, and financial health. The blue line is the investor who invests in index funds and high yield bonds. The orange line is the investor who keeps most of their money in cash and invests the rest in low yield bonds, utilities, and companies that are so "safe" because they've been around forever but who's businesses are being disrupted by new innovators. And the red line is the investor who buys companies that are trending on Twitter and Reddit.
By nature people are poor risk managers, preferring loss avoidance to profit maximization, even though in the long run this delivers poor returns. If you decide to play it "safe" and not invest in anything volatile, keeping most of your money in the bank, you face the near certainty of inflation eroding the value of your cash. Every decision involves risk. There is nothing you can do that involves zero risk.
For example, let's say John is panophobic (afraid of everything). He's in his home a few miles from the grocery store. He's hungry and is about to go to the store to buy some groceries to make lunch. As he's about to get in his car, he remembers he saw on the news that morning that traffic accidents increased in his state by 1% over last year. He decides the risk of dying in a car accident is too great, so he decides to walk. Upon thinking further, he sees that he'll have to cross the street 4 times. But that's risky. "I could be hit by a truck and die!" he thinks. So he enlists a driver from DoorDash to pick up his food, and it arrives 40 minutes. He's about to dig in when it occurs to him that the chicken Caesar salad might have lettuce that wasn't washed properly, or the chicken could have lethal parasites, or his DoorDash driver may have poisoned the food. "Too risky!" he exclaims, and decides it's safer just not to eat. "It's not worth the risk." So John lives the next 3 months in his home perfectly safe from car accidents, getting run over, and food borne illness until he gradually and safely dies of starvation.
Everything involves risk.
Systematic vs specific risk
Systematic risk is risk that affects an entire market as a whole. Systematic risks include things like macroeconomic conditions, wars, politics, interest rates, currency values, or pandemics.
Specific risk is risk that affects a smaller part of the market, whether it's an industry struggling or an individual company. Examples of specific risk include changes in management, product recalls, regulatory changes, and new disruptive competitors.
Investors can use diversification strategies to guard against specific risk. Systematic risk is very difficult to guard against, although if you have the patience, the best strategy is to wait out the market lull. By definition, nobody can predict a market decline. If they could, the market would already reflect such predictions, which would make the decline not occur.
Conclusion
Be a long term investor. Invest in great companies providing great products and services that others want and need. Volatility does not equal risk in the long run.
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