Risk vs. Volatility: What You Need to Know
Risk vs volatility: these two terms are often mistaken for each other by investing experts and newbies alike, but they mean very different things.
In the words of Warren Buffett, “Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”
Here are the key differences between risk vs volatility (and how to use their differences to your advantage as a value investor).
- Risk is the probability of a loss and the amount of money you could lose.
- Volatility is when the stock market swings up and down in price.
- A volatile stock price doesn’t necessarily mean that a company is a riskier investment.
- A stable stock price doesn’t mean that a company is a less risky investment.
- Invest in what you know and analyze a company’s fundamentals to lower your risk of losing money.
- Use volatility to your advantage: buy quality companies when stock prices are low.
What is risk?
When it comes to investing, here’s a good definition of risk (according to the Value Investing Bootcamp):
“Risk is the probability of a loss and the amount of money you could lose.”
Many people don’t invest because they’re afraid of the risk. But risk can actually be used to your advantage when investing – if you know what you’re doing.
RISK INCREASES IF YOU VIEW INVESTING LIKE GAMBLING
First of all, don’t treat investing like a trip to Las Vegas. This approach increases your risk.
Say that you’re playing roulette. You can bet on any color or number. The closer your guess to the actual number spun, the more money you’ll win. But because the odds of you winning are solely based on luck, you’re following a dangerous strategy. You could quickly go from having $$$ to $0 in the blink of an eye.
Picking individual stocks without taking the company’s fundamentals performance is like playing roulette. You’re merely speculating or gambling (which can’t even be considered investing). Analyzation will be involved in investing decisions.
RISK IS PART OF INVESTING
Secondly, investing always comes with a degree of risk. You can never be certain that you’ll make or lose money on an investment.
So how can you lower your investment risk? According to Warren Buffet, “Risk comes from not knowing what you’re doing.” Buffett also says that value investors should avoid two specific types of risk:
- The risk of a permanent capital impairment: a company’s stock price goes down and stays down for a very long time. Or the company may go bankrupt.
- The risk of inadequate return on capital: a company doesn’t earn enough to justify the money they’ve spent.
To avoid these risks, base your investing decisions on the company’s fundamentals and intrinsic value (what they’re actually worth vs. what the market says they’re worth).
Also look at how cheap the stocks are. If the stock prices are lower than a company’s intrinsic value, the company might be a good investment.
HIGH RISK DOESN’T GUARANTEE HIGHER REWARDS
Warren Buffet also says that risk/reward is not positively correlated for value investors (aka high risk doesn’t necessarily mean high reward). This is completely OPPOSITE of what most investors say — they state that to earn more money, you need to take on more risk.
Not with value investing. As a value investor, high risk can equal lower returns. You can actually purchase stocks at a lower price equals lower risk and higher upside (or more money earned).
By taking a lower purchase price, you minimize your risk and maximize how much you could earn. Declining stock prices make the stock less risky, as long as the fundamentals of the company are solid.
What is volatility?
Volatility is when the stock market swings up and down in price. Consider events where the stock market was crazy volatile:
- 1929 Stock Market Crash
- Dot-Com Bubble
- 2008 Great Recession
- 2020-21 Pandemic
During these periods, stock market prices rose and fell consistently. Look how volatile the S&P 500 was over a 100-year period:
The lesson here? Volatility is inevitable in the stock market.
But high volatility gives you the perfect opportunity to take advantage of investor panic, purchasing quality company stocks at bargain prices.
VOLATILITY DOES NOT EQUAL RISK
As mentioned, many experts and stock market formulas assume that risk equals volatility. They say that a stock that swings up and down in price (or is volatile) is riskier than a stock that has a stable price.
But here’s the thing; price says little about a company’s actual value or performance. As the value of a company goes up, its stock price might go up and down. This doesn’t mean that the company is a risky investment.
It instead provides the perfect opportunity to buy the stock when the price is low and sell when the price is high.
On that same note, uncertainty — such as being unsure what the market will do — is also not risk. Uncertainty, just like volatility, can create opportunities to make money. As investors overreact to uncertainty (such as a billion dollar company getting sued), you can buy temporarily distressed companies at bargain prices.
VOLATILITY SHOULDN’T BE VIEWED EMOTIONALLY
The trick is to not get emotional in the midst of volatility and uncertainty. You increase your risk if you buy or sell stocks because you’re worried or excited about a swing in market prices.
Risk vs Volatility
In short, a volatile stock price doesn’t necessarily mean that the company is a risky investment. Neither does a stable stock price.
As an example, Warren Buffett owns a company called See’s Candies. The business loses money two-quarters of the four quarters of the year since people primarily purchase candy during the holidays.
But even though the company has a huge volatility of earnings, it’s one of the least risky businesses that Warren Buffett knows. Wonderful businesses can have significant volatility but great results. You also have terrible businesses with stable earnings.
Use risk vs. volatility’s differences to your advantage
Treat risk and volatility as two separate concepts to make the best investing decisions for you. First of all, lower your risk by investing what you know. Understand that risk can’t be eliminated, but it can be reduced.
As a value investor, don’t chase after new hot companies and stocks. Instead, invest in industries and businesses that you feel comfortable with or ones that aren’t overly complex.
In the words of Warren Buffett, “Never invest in a business you cannot understand.” Once you’ve selected the companies you’re interested in, follow these steps:
- Analyze that company’s fundamentals to lower your risk even more.
- Buy quality companies at bargain prices when prices are volatile.
In other words, as other investors panic and prices for great businesses drop (aka they’re volatile), you can purchase excellent stocks. As the prices eventually rise to the company’s intrinsic value, you can sell to make money on your investments.
Discover more about avoiding risk when you sign up for the Value Investing Bootcamp: How to Invest Wisely on Udemy. This course helps you learn how to become a successful value investor, step-by-step. Check out the course here.