Why you don’t need to be afraid of the ugly brother of risk

“Volatility,” as it’s used in investing, sounds like something dirty, dangerous and, well, volatile.

“Pound Sinks… as Traders Brace for More Volatility,” warned a headline on Bloomberg. “Wall Street Unnerved by Oil’s Volatility,” read another recent market news headline.

Volatility is often understood as risk. But risk, volatility’s better-understood brother, refers to the chance that you’ll lose money in an investment. Volatility, on the other hand, is a measure of the change in the price of an investment over a particular period of time.

Risk and volatility are very different.

The name Bernie Madoff is associated with the biggest fraud in the history of Wall Street. Madoff lost an estimated US$50 billion for investors. Surprisingly, most of these people were sophisticated, experienced investors. How did Madoff get away with this?

Madoff’s scheme was complex, but crucially, Madoff’s funds showed steady profits. He made 12 to 14 percent returns like clockwork for years. It looked like there was little volatility, so investors thought Madoff was doing a good job and their investments were safe.

But their actual risk was very different from the apparent volatility of their investments. They ended up losing everything.

Financial academics define volatility as the standard deviation of the change in the price of a stock or other financial instrument relative to its historic price over a period of time. In other words, it’s how big the price swings are on a daily, weekly or monthly basis.

If the $30 shares of Company A trade between $25 and $35 per share in a week, it’s considered more volatile than Company B’s $30 stock that trades between $31 and $29 over the same time period. Both have an average price of $30 per share, but Company A’s stock is more volatile because of the bigger price swings.

But does that mean it’s a riskier investment? The price swings certainly make company A’s stock feel riskier.

Let’s say you and a friend visit an amusement park. Two rides begin and end at the same entrance. One ride is a roller coaster, the other is a small train. You enjoy thrills, but your more sedate friend does not. So you agree to ride the roller coaster, and he rides the slow-moving little train.

Five minutes later, you both meet back where you started. You both spent the same amount of time on a ride, but the roller-coaster moved up, down and around a lot, while the train circled placidly. The roller-coaster offered lots of volatility versus the train, but in the end, both riders converged at the same place.

So which ride was riskier?

While the gyrations of the roller coaster were far greater than those of the train ride, the relative risk of the two rides was similar. Assuming proper maintenance, your chances of being injured on the roller coaster were probably only very slightly higher.

As we’ve discussed on several occasions, humans evolved over hundreds of thousands of years to function and survive in a world where death lurked around every tree and rock. All the irrational things that humans do as investors can be traced to hardwired behaviours from our ancient past.

And back in prehistory, many dangerous things moved fast. An approaching turtle provoked a different response than a charging tiger. When things happened fast, we didn’t have time to think, so our bodies compensated by developing involuntary behaviours that gave us the best chance for survival.

That’s why volatility in our portfolios is so stressful. A stock whose price bounces all over the place – up 5 percent one day, down 5 percent the next – makes us feel uncomfortable. We feel this price action is “risky.”

However, a stock that is quiet, with a share price that moves about calmly from day to day, does not make us as nervous. We feel this stock is safer. But, as we’ve shown, low volatility is not the same as low risk.

In fact, some volatility is good. The most volatile stocks are often those of smaller, fast-growing companies. While a few of these “riskier” stocks may not do very well, some might be huge winners over time, despite day-to-day volatility.

The key is not to fear volatility, but to expect it. Study the history of the markets. The best opportunities come when there is the most volatility. And don’t just assume those dull stocks in your portfolio are “safe.”

Also, it helps to add “uncorrelated” assets to your portfolio. These are investments that may go up when stocks go down. Gold and high quality bonds, for example. And always keep some cash on hand to buy good companies when they get cheap.

Volatility and uncertainty are a fact of life – good and bad things happen unpredictably. Trying to take the uncertainty out of life (or your portfolio) is impossible, and won’t get you any further ahead.

Embrace volatility for the opportunity it presents. After all, no one goes to an amusement park just to ride the baby train.