Modules for Investors
More about risk and risk management
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Risk and volatility
In the previous chapter, we saw the different types of risk, both systematic and unsystematic. In this one, we’re going to explore two concepts - risk and volatility - and the relationship between them. Many budding traders and investors often tend to confuse these two terms. This leads to the notion that investment options that are highly volatile are also highly risky. Let’s try to unravel these concepts and see if that’s actually the case.
In the previous module and in the first two chapters of this one, we’ve discussed risk in great detail. So, without going into too much detail, let’s just recall what the concept of risk is all about.
Risk is basically the possibility of the actual returns from your investments being different from the expected returns. It indicates the chances of your investment going into a loss. If your investment option has a high probability of losing value, then it is termed as a high-risk asset. Stocks, commodities, and derivatives are some examples of high-risk investments.
Conversely, if your investment option has a low probability of going into a loss, then it is termed as a low-risk asset. Bank deposits, bonds, and government securities are good examples of low-risk investments.
Since we’ve discussed risk extensively before, let’s now move on to volatility.
What is volatility? Volatility is essentially a measure of the extent of price movement of an asset. An investment option whose price moves sharply on either side is known as a highly volatile asset. The prices of these kinds of assets tend to swing wildly and are often unpredictable.
On the other hand, an investment option whose price doesn’t move much on either side is known as an asset with low volatility. The prices of these kinds of assets are smooth, don’t swing wildly, and are often quite predictable.
If you’ve ever tracked the stock market movement during important events like RBI interest rate announcements or budget speeches, you would know what volatility is. The price of stocks that trade smoothly during regular days may start to swing wildly during such important events. This sudden increase in the extent of price movement of such assets is caused due to an increase in volatility.
Risk and volatility: An analysis
As you can see from the above explanations of risk and volatility, they’re far from the same thing. And so, let’s take a look at a few things that differentiate risk from volatility.
- Volatility can work in your favour, whereas risk cannot
Since risk signifies the possibility of an asset losing its value, it is something that can never be favourable. However, volatility can at times work in your favour. Consider this situation. Assume that you’ve taken a long position on a particularly volatile asset. Now, when the price of an asset swings wildly upward, the volatility is said to have worked in your favour, right?
Essentially, volatility indicates price movements on both sides. Risk only pertains to unfavorable price movements, which lead to losses.
- Risk can be controlled, whereas volatility can’t be
There are plenty of different ways through which you can reduce the investment risk of an asset. Diversification and hedging are a couple of the most popular ones used by traders and investors to reduce and control risk.
Volatility, on the other hand, is a force that’s completely out of your hands. The wild swings in the price movements of an asset occur because of an increase in trading activity caused due to a shift in the market sentiment. And so, there’s absolutely nothing that you can do to control or reduce volatility, except maybe ride it out patiently.
- Risk is subjective; volatility is not
Risk, more specifically, risk appetite and tolerance, is a subjective affair. Though commodities are considered to be high-risk investments, you may find it more bearable if you have a higher risk tolerance and risk capacity compared to another investor who has lower risk tolerance and risk capacity.
The ‘perceived’ level of risk for an asset changes in accordance with the person’s ability and willingness to bear losses. However, the same cannot be said about volatility. Volatility is objective and stays the same for you and every other investor in spite of your varying perceptions, investment styles, and capacities.
- Volatility fluctuates; risk tends to stay the same
Let’s look at this in terms of a single stock - say Infosys Limited. The risk factor for this stock usually tends to stay the same over the years. Even if there are any changes, it's highly likely to be marginal in nature. But volatility, on the other hand, tends to keep fluctuating ever so often. One day, the volatility in the Infosys Limited counter may be low, whereas on another day it can spike up considerably.
- Volatility tends to be short-term in nature, whereas risk is long-term
Continuing on from the previous point, volatility is almost always short-term in nature. Since it is primarily caused by a sudden increase in trading activity and due to changes in market sentiment, it tends to be very short-lived.
You can never see a stock being volatile for months or years on end; it generally lasts only for a few days or a few weeks. When it comes to risk though, it tends to be long-term. The risk factor for a particular asset doesn’t shift ever so often. It tends to remain the same throughout for years on end.
- Volatility can be used to determine risk, but not the other way around
By measuring the volatility of an asset, you can, to a certain extent, gauge its risk. Highly volatile assets typically possess higher levels of risk. This is simply due to the fact that the chances of you incurring a huge loss goes up if the price movement goes against your favour. That said, by measuring risk of an asset, you can never gauge its volatility since high risk assets may not always be highly volatile.
As you can see from above, risk and volatility are not the same things. It is important for you to properly understand the distinctions between the two before investing. This way, you can ensure accuracy in your investment decisions.
A quick recap
- Risk is basically the possibility of the actual returns from your investments being different from the expected returns.
- It indicates the chances of your investment going into a loss.
- Volatility is a measure of the extent of price movement of an asset.
- An investment option whose price moves sharply on either side is known as a highly volatile asset.
- On the other hand, an investment option whose price doesn’t move much on either side is known as an asset with low volatility.
- Volatility can work in your favour, whereas risk cannot.
- Risk can be controlled, whereas volatility can’t be.
- Risk is subjective, but volatility is not.
- Volatility fluctuates, while risk tends to stay the same.
- Volatility tends to be short-term in nature, whereas risk is long-term.
- Volatility can be used to determine risk, but not the other way around.