Volatility vs. Risk (They’re not the same!)

It may seem like a trivial distinction, but it’s not. Let’s assume that “risk” refers to the chance that you’ll lose money on a particular investment. (While–in my opinion–this isn’t the best definition of risk, it is the most popular one. But that’s a topic for a later post.)

Risk is a function of time. Volatility is constant.

Let’s say you’re saving up money for a down payment on a home. You expect to need the money sometime within the next 3-5 years. Common sense tells us that the stock market is probably a poor place to invest that money. Over any 3-year period, there’s no telling what the stock market might do. (It is, after all, quite volatile.) It could be much lower in 3 years than it is now. Investing your down payment money in the stock market would be quite risky.

Now, let’s say you’re also saving up money for retirement, and you know that you’re not going to need this money for at least 20 years. Conventional wisdom tells us (correctly) that the stock market is a great place for this money. It’s a practical certainty that the stock market will be much higher 20 years from now than it is today. Suddenly, despite the fact that the stock market is still volatile, it’s no longer risky in this particular situation.

What’s the difference? The time frame. What do we learn?

• An investment class’s volatility is constant. Stocks will be volatile throughout a 1-year period, a 5-year period, or a 50-year period. Stocks never move up in a straight line.
• Risk, however, is not constant. It’s a function of time. For stocks, time and risk are inversely related. (That is, the longer you have for your money to grow, the less risky stocks become.)

So what’s the value of this distinction? The way I see it, the value is this: Understanding that an investment can be volatile without being risky should give us courage.

Hopefully, it will give us the courage to put more of our money into those investments that will provide us with the most growth between now and the time we need the money.

Hopefully, it will give us the courage to understand that declines in the market do not mean stocks are unsafe. They simply mean that stocks are volatile. (And we already knew that, now didn’t we?)