June 25, 2014

Risk, Not Volatility, Is the Real Enemy

What would you do if your investments lost 10% in a single day?
A) Add more money to my account.
B) Hold steady with what I’ve got.
C) Yank my money; I wouldn’t be able to stand any more losses.

If investors buy the right investments but sell them at the wrong time because they can’t handle the price fluctuations, they may have been better off avoiding those investments in the first place. Most investors are poor judges of their own risk tolerance, feeling more risk-resilient in up markets and more risk-averse after market losses. However, focusing on an investor’s response to short-term losses inappropriately confuses risk and volatility. Understanding the difference between the two and focusing on the former is a potential way to make sure you reach your financial goals.

Volatility encompasses the changes in the price of a security, a portfolio, or a market segment, both on the upside and downside, during a short time period like a day, a month, or a year. Risk, by contrast, is the chance that you won’t be able to meet your financial goals or that you’ll have to recalibrate your goals because your investment comes up short. So how can investors focus on risk while putting volatility in its place?

The first step is to know that volatility is inevitable, and if you have a long enough time horizon, you may be able to harness it for your own benefit. Diversifying your portfolio among different asset classes can also help mute the volatility. It helps to articulate your real risks: your financial goals and the possibility of falling short of them. Finally, plan to keep money you need for near-term expenses out of the volatility mix altogether. Investing in securities always involves risk of loss. Diversification does not eliminate the risk of experiencing investment losses.