A mistake a lot of investors make when they first start out is thinking risk and volatility are the same thing. Although the two concepts are interconnected, there is a difference between them and understanding what they are and how they could affect your investments is vital.
What is volatility in investing?
Volatility is a measure of how much the price of an investment goes up and down over time. If an asset rises and falls dramatically, it is seen as having high levels of volatility. Conversely, if the price of an asset moves in a stable and predictable way, it is seen as being low volatility.
In and of itself, volatility isn’t necessarily a negative trait and it is normal to experience some level of volatility across the investments you hold. Indeed, higher levels of volatility can represent an opportunity for experienced investors, as it means they can aim to buy more when the price falls or trim their gains when the price rises. However, “timing the market” in this way isn't easy and, if you get it wrong, it can have a negative impact on returns.
As long as you have a long enough period over which to invest, you should be able to ride out volatility, hopefully seeing a general upward trend when you average out the highs and lows. The problem comes if you need access to your investments quickly, in which case there is a risk that you may have to sell when the price is low. Similarly, volatility risk becomes a more pressing issue when you have a shorter investment horizon because you may not have long enough for the price to go back up again if there is a significant fall. This is why financial advisers often encourage their clients to switch to lower-volatility assets towards the end of their investment journeys.
It’s important to note that, although higher volatility investments generally offer higher returns over the medium-to-long term, this isn’t guaranteed. There have been times when, even with a great deal of movement in price, an investment will generally be trending down over time. For example, during a recession, while there may be volatility in the price of a particular investment (such as a company share), it can ultimately fall and, indeed, take many months - or even years - to return to pre-recession levels.
What is risk in investing?
The concept of risk is subjective, with one person’s idea of high or low risk often differing from someone else’s. Generally speaking, a broad definition of risk is the likelihood that a particular investment will lose you money over a period of time, or not return as much as you expected it would.
Breaking it down further, there are specific types of risk that can affect your investments:
What is volatility risk?
As discussed above, the problem with volatile investments is that, if you need to access your money in the short term, you may be forced to sell at a point where the price has fallen sharply and, therefore, make a loss. Volatility risk can also be an issue when a bumpy investment journey leads an investor to lose sight of their longer-term strategy and buy and sell holdings based on short-term fluctuations in the price. They can, in effect, lose their nerve when they see the investment plummeting and rush to sell to avoid further losses, but then miss the upside when that holding recovers and the price goes back up.
What is liquidity risk?
There is a risk associated with not being able to access the money tied up in an investment quickly and easily. Some investment types, for example property, are relatively illiquid, meaning there is a risk of not being able to access your money if you need to do so quickly. Conversely, assets like shares, which are freely traded on stock exchanges, have good levels of liquidity, which means you can buy or sell when you want and action your decisions quickly.
What is inflation risk?
Although it is generally agreed that higher-risk assets offer the potential for higher returns, there is a risk present for low-risk/low-return assets, for example, cash. This is the risk that inflation erodes the value of the investment as it is higher than the return being offered. This means your investment may actually be worth less in the future.
What is the relationship between risk and reward in investing?
There is a known correlation between the level of risk an investment poses and the level of return it can potentially offer. In fact, “risk” boils down to the potential an investment has to either go up by a significant amount or to fall substantially, meaning you lose money. It is this uncertainty that translates into risk: you can’t know for sure if it is going to perform well or put your initial capital at risk.
While no investment has zero risk attached to it, holding your money in cash or government bonds offers far greater clarity and certainty on what return you are likely to get. However, by increasing your risk exposure and investing in, say, equities, you could end up making significantly more money. The trick is finding the right balance between the level of risk you are willing to take on and the returns you would like to achieve.
What is risk tolerance or "risk appetite" in investing?
If you are starting out in investing, you can expect to be faced with questions about your appetite for risk. Indeed, whether you are in conversation with a financial adviser or setting up an account with a robo-adviser or other investment platform, your tolerance for risk is something you will be required to assess and continue to monitor over the life of your investment.
Simply put, your risk appetite will largely be determined by your capacity for loss. This means looking at how you’d feel if your investment fell by, say, 5% over 20 years or, alternatively, 20% in a single year. The aim is to balance what you want your investments to return with the level of risk you can tolerate. While some investors will be happy to take on high levels of risk in order to potentially maximise returns, others will feel more comfortable sacrificing some performance in order to minimise risk.
Your risk appetite is likely to change across your lifetime, with life events such as having children, changing jobs, moving house or nearing retirement all affecting how much risk you are willing to take on in your investments. This is why risk appetite should be reassessed regularly.
You can assess your own attitude to risk by either using riskprofiling.com which is a paid-for service (costing £30) or you can register with an online investment manager, such as Wealthify*, and use their risk profile questionnaire for free. They will also provide you with a portfolio recommendation but there is no obligation to invest.
How can you reduce investment risk?
A key tool in managing risk is having a good level of diversification across your investments. This means creating a portfolio that includes different asset classes, including equities, bonds, cash and other investment types. It also means checking the exposure you have on a geographical level, as well as across different industry sectors.
By doing this, you minimise your exposure by not “putting all your eggs in one basket”. You spread the risk across a pool of different investments, so while one area may go down, others will hopefully stay the same or go up. This is also helpful when it comes to volatility, as you will hopefully be more able to tolerate short-term fluctuations in one area of your portfolio, if the others are relatively stable.
If you are new to investments and not confident about making your own investment decisions, it’s a good idea to speak to a financial adviser about your specific goals and risk appetite. Read our article on "10 tips on how to find a good financial adviser". Alternatively, there is a range of robo-adviser investment platforms that take you through a series of questions to determine your risk tolerance and then suggest a portfolio that is suitable for you. Have a look at our "Robo-adviser Best Buy table".
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