Confusing Risk and Volatility

Reuters writes that we should never confuse risk and volatility.

Of the many lazy and dangerous ways of thinking about investment these two rank near the top: that risk equates with volatility and that risk and rewards are a straight trade off.

Both are overly simplistic and both lie at the heart of some of the most colossal errors in recent finance. And while both contain large amounts of truth at their core, both concepts represent shorthand versions of reality rather than tools which always, or even usually, work.

Over the long term of an investment, the only reason to fear volatility is if it threatens to result in permanent loss. We have written about long term investing and how five to ten years is an appropriate time to put money into a promising investment. One of the reasons for this time frame is that investments can be volatile and market timing is always less than perfect.

Investors who choose the most risk-free investments always give away the potential for greater profits. When we wrote about how to invest without losing any money, we wrote about these investment vehicles, in order of lesser to greater risk:

• Bank deposits with Federal Deposit Insurance
• US Treasury Bills, Notes, and Bonds
• Investment Grade AAA and AA Bonds
• Long term value investing based on intrinsic value assessment

Within any investment portfolio there should always be a place for these investments. Then, when a person needs money, they will not need to sell a stock, for example, when the market has just crashed. By in large, the closer one gets to retirement, the more conservative should be one’s portfolio. Nevertheless, there will always be a place for long term investment in stocks and others investment vehicles of which short term volatility is normal.

When Are You Willing to Accept the Risk?

Some of the most spectacular profits in real estate, bonds, or stocks come from buying in a depressed market and selling when prices return to normal. The problem is that many times there are extremely valid reasons why an investment has lost value. CNBC writes about bond investors buying risky high yield junk bonds. Many are betting that the mid-range volatility that has taken bond prices down will result in an upward swing in the reasonably near future and certainly before some of those bonds go into default.

This is a matter of market timing and is a valid reason to equate volatility with risk. Anyone who is an expert in buying and selling bonds is welcome to engage in the business of picking up junk bonds at the right time. But, anyone who does not have a clue about market timing in this sector needs to avoid investing in an area where they have not knowledge or expertise.

Is a Volatile Investment a Risky Investment? PPT