Relationship between Volatility and Risk
Market risk and volatility are two terms that are heard a lot by many risk management professionals. To the layman, the terms may sound like synonyms. This means that the average person tends to think that volatility and risk mean the same thing. However, this is not true. The terms are related and have a similar meaning. However, they are not the same. It is important for a risk professional to understand the subtle difference between these two firms. The same has been explained in this article.
Risk vs. Volatility
Let us first understand the meaning of the term volatility. Volatility simply means that the value of the asset will change rapidly from one day to another. In statistical terms, this means that the values in the distribution have a higher dispersion from the mean. Volatility is often considered to be a precursor to risk. However, it is not the same as risk itself.
Risk is the possibility of not getting the expected returns. It needs to be understood that when the market is volatile from day to day, the notional value of your assets may go up or down. However, it does not translate into a loss till the loss is booked. This is one of the reasons why volatility does not entail risk.
The difference between volatility and risk becomes clear when we look at the returns given by competing investment classes. Most historical analyses conducted conclude the same thing i.e. equities provide the highest return in any ten-year period as compared to real estate, fixed deposits, and even debt. Now, the value of equities fluctuates wildly on a day-to-day basis. However, over a longer period of time, they tend to provide predictably higher returns. Hence, equity can be said to be volatile but not risky.
Different Characteristics of Risk and Volatility
There are some fundamental differences between the characteristics of risk and volatility. These differences have been listed below:
- Risk cannot be truly measured whereas on the other hand volatility can be measured. There are several measures of volatility such as standard deviation, beta, etc. These measures are used as proxies in order to measure the risk but they are not the measures of risk.
- The defining characteristic of risk is the presence of capital loss. If there is no capital loss, there is no risk! On the other hand, volatility has no relation with an actual capital loss. It is just the fluctuation in values before the investment is finally sold off.
- Organizations have the ability to manage and reduce risk at their level. It is within their control to reduce risk. However, they do not have any control over the volatility. This is because, by definition, volatility is the fluctuation in prices. An individual organization is generally a price taker in competitive financial markets. This is the reason that it has no control over the market prices and hence has no control over the market volatility
- Risk is a forward-looking concept. It is related to a probabilistic event that may happen in the future. However, volatility is a backward-looking concept. It is defined by the changes in the value of an asset in the past. The assumption is that the asset will behave in the future in the same manner that it did in the past. This is why volatility is a proxy measure for risk.
Volatility is Not Always Bad!
It is important to understand that the investors behavior aimed at deliberately avoiding volatility is somewhat irrational. It generally stems from the fear which equates volatility with risk. However, if one removes the phobia and looks at volatility in a rational manner, they can see some advantages as well.
- Volatility offers investors the opportunity to buy assets at a low cost. It is this volatility that causes markets to behave irrationally in the short run and underprice the assets creating opportunities for many investors
- Volatility is only temporary. Hence, if investors are able to stay put despite the roller coaster ride that highly volatile markets bring along, they are likely to enjoy greater returns than those provided by other asset classes.
- Volatility gives investors the ability to book profits and exit the trade in the short run. It is because of volatility that wild upswings in the price might take place.
Hence, it can be said that risk and volatility are two related concepts. The difference between the two is the time horizon of the investor. If the investor has a very short-term time horizon, then they will be forced to sell at whatever price is prevailing in the market. This is where volatility will actually translate into risk. However, if the investor has a fairly long investment horizon, then the volatility may not turn into a risk.
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