Volatility and risk: understanding the difference
While they may seem similar at first glance, volatility and risk are quite different.
Volatility and risk are two factors that impact your investment portfolio. Your time horizon and personal circumstances are key to determining how much risk is appropriate given your investment goals.
Risk is the amount of uncertainty an investor is willing to accept in order to achieve a desired return. It includes the possibility of losing some or all of the investment. The amount of risk an investor can tolerate is personal. It varies between individuals based on their willingness, ability and time horizon for investing. For example, if an investor is losing sleep because they are worried about how their investments are performing, they are taking on more risk than they can tolerate.
Volatility (as measured by standard deviation) is a statistical measure of the dispersion of returns for a security, mutual fund or market index. It refers to the amount of variation in a fund’s value over a period of time in relation to its long term average. A fund with higher volatility will have returns that have a higher variance around its average. They typically have higher returns but also have a greater chance of losing money. A fund with lower volatility tends to have returns that change less over time. They typically have lower returns and may have a lower chance of losing money. Stocks and equity mutual funds are typically more volatile than money market and fixed income mutual funds. Volatility is also a common measure of risk.
Below are some tips to keep the impact of risk and volatility in check when it comes to your investments:
- Know yourself. Understand your tolerance for risk and tailor your portfolio accordingly. If you can’t stomach volatility, don’t buy volatile investments. Keep in mind that meeting investment objectives often means accepting some risk. As such, taking on some risk means realizing there will likely be volatility in investment returns.
- Focus on the end game. Short-term market fluctuations can cause even the most seasoned investor to make poor decisions. It’s important to focus on your long-term investment goals and stick to a disciplined plan to avoid making moves that may be dictated by an emotional reaction to short term market movements.
- It’s all about balance. Investors tend to let recent experiences disproportionately impact their decisions. For example, if an investor recently lost money, they may be overly fearful of more losses. Purchasing investments that are less volatile with lower standard deviations such as balanced funds might make it easier for investors to resist the temptation to sell if markets fluctuate. Diversification can help reduce volatility at the portfolio level.
Volatility, risk and your portfolio
Working with an advisor can help you build a portfolio with investments suited to your long-term goals and tolerance for risk. An advisor can also help you avoid making emotionally-driven decisions. You can’t separate volatility and risk but you can manage their impact on your portfolio.
© Sun Life Global Investments (Canada) Inc., 2014. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies. This piece is intended to provide you with general information and should not be construed as providing specific individual financial, investment, tax, or legal advice. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Please read the prospectus before investing.