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All investing involves risk. No matter which assets you own, risk means that they can lose some or even all of their value due to unforeseen market developments.
Volatility is another investing fact of life. The value of any given asset never remains static for long, and the magnitude of gains and losses can be enough to scare the daylights out of even the most seasoned investors.
Risk and volatility are often used interchangeably, but at the end of the day they’re different things. Let’s take a closer look at these key investing concepts to better understand their similarities and differences.
What Is Risk?
In investing and finance, the risk is the possibility that an investment will fail to achieve an expected return. In other words, risk represents the potential for an asset to lose some or all of its value.
A bedrock principle of investing is that risk and return are directly proportional. Riskier investments offer the possibility of greater returns, while less risky assets hold out the promise of lower returns.
Investors demand better returns from taking on more risk because they assume a greater chance of losing money.
Risk nearly always describes the possibility of losing money. Note that sometimes investment professionals refer to “upside risk,” which represents the possibility of earning a greater than expected return on investment.
Types of Investing Risk
There is an entire universe of risks in financial markets. Here are a few of the most notable flavors:
Business risk is the possibility that a company cannot make good on obligations to the owners of its stocks and bonds. Shares of stock represent an ownership stake in a public company, while bondholders lend money to companies and governments.
The value of each depends on the issuing companies and governments remaining solvent. If companies fail, their assets are liquidated and the proceeds are used to pay bondholders and shareholders (government defaults are a more complicated subject).
Interest Rate Risk
Interest rate risk is the possibility that interest rate changes could negatively impact an investment’s value.
Central banks like the Federal Reserve control a nation’s monetary policy. They change interest rates to stimulate or slow an economy as necessary.
Inflation is the general upward movement of prices across an economy, gradually reducing money’s purchasing power. Inflation risk is when rising prices eventually erode investment returns.
Liquidity risk is the possibility that investors will not be able to buy or sell securities when they want. The inability to sell a position can increase losses, while the failure to purchase an asset can result in a missed opportunity.
Currency risk is a threat for investors involved in cross-border transactions and holding foreign assets. Changes in the value of a currency in the forex market can result in unexpected gains or losses.
Changes in the prices of raw materials can hurt companies, eroding their financial results and negatively affecting stock prices.
Government policies and political developments can impact companies positively and negatively, as can the state of the economy. Negative turns in either can diminish investment value.
How to Manage Risk
While reams can be written about managing risk, there are two key strategies investors need to understand to manage and mitigate risk.
Asset allocation is the process of creating a portfolio that attempts to balance risk and return. The portfolio manager adjusts the percentage of different asset classes based on the investor’s risk tolerance.
Diversification involves investing in a wide variety of different securities and asset classes that are uncorrelated. The positive performance of some investments compensates for the negative performance of others.
What Is Volatility?
Volatility is a measure of how much the price of an asset fluctuates over time. It concerns how quickly the price changes, how often it changes, and how much.
Think of volatility as the kissing cousin of risk. For a short-term trader, market volatility offers the possibility of bigger gains and the risk of bigger losses. Speculative traders embrace volatility as the main engine of their profits.
In the bigger picture, volatility involves asset price changes, not asset values. And it’s important to understand that price and value are not identical.
A stock’s price might fluctuate wildly, but the company’s value can remain unchanged. What has changed is the price market participants are willing to pay to own that intrinsic value, and prices swing significantly depending on market conditions.
For long-term investors, volatility is much less of a concern. Short-term price fluctuations tend to even out over time, which is why investors with long time horizons typically invest more of their portfolios in stocks.
As the time horizon shortens and the investor gets closer to retirement, the allocation to equity is reduced while investment in bonds is increased. Bonds are much less volatile than stocks, although they carry varying levels of risk.
Risk can be a highly subjective phenomenon difficult to quantify and measure. Volatility is more straightforward and objective, making it easy to measure.
The Chicago Board Options Exchange (CBOE) Volatility Index—commonly known as the VIX—is one measure of volatility. The VIX tracks the volatility investors think the S&P 500 index will experience over the next 30 days.
Market professionals refer to this as “implied volatility” because the VIX tracks the options market, where traders make bets about the future performance of different securities and market indices, such as the S&P 500.
How to Manage Volatility
The simplest way to cope with volatility is to ride it out.
Buy-and-hold investors hardly care about short-term volatility, which might be the best attitude about the phenomenon. By ignoring volatility and holding on to your investments, you forestall short-term losses from selling at the wrong time.
Some investors make the mistake of thinking they can enter and exit the market when conditions are optimal, but mostly this ends up locking in losses and paying a higher price later. Timing the market is a fool’s errand.
But volatility also creates opportunities. As mentioned above, volatility is based on market perceptions rather than value. A drop in stock prices can offer an advantageous entry point to buy cheap stocks, but this is only an opportunity if you understand the fundamental value of the asset.
Risk vs. Volatility
Understanding that risk and volatility are not the same makes it much easier to manage both.
Long-term investors need a financial plan consistent with their risk profile. The investor who understands volatility is better able to maintain discipline. The investor who doesn’t may be tempted to make unfortunate decisions, such as selling in a panic when the market drops precipitously, thus locking in their losses.
The best advice is to develop a strategy that manages risk through asset allocation and mitigates risk through diversification. Keep emotion in check when markets are volatile, stick to the plan, and reap the benefits of a disciplined long-term strategy.
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