Why it’s important to understand the difference between risk and volatility

Category: Australia & News & United Kingdom

How you invest your money, including your pension fund and other savings, is important to your financial future.

Consistent investment growth boosts your wealth and can help offset the negative effect of inflation reducing the purchasing power of your money. 

Your investment plan should be designed to give you the best possible chance of achieving the financial goals you set yourself, such as accruing enough money to live a comfortable life in retirement. 

And, considering the importance of your investment strategy, it can help to have at least an outline understanding of how investments work. 

One of the keys is to understand investment risk and volatility. They are two common terms that are often used interchangeably but are very different.

Appreciating the difference between the two can give you a handy insight into your investment strategy. Furthermore, being aware of how they differ can also give you valuable peace of mind. 

Volatility is the natural fluctuation in share and market values

Volatility is one of the most common ways to describe the amount that asset values fluctuate. In volatile periods, share prices can suddenly move up and down. Conversely, at less volatile times, their performance is smoother and – as a result – more predictable.

It’s the unpredictability, and the sudden rise and fall in share or fund prices, that can make market volatility so unsettling for any inexperienced investor. 

In reality, a certain level of volatility is inevitable in stock markets. Values are based on the performance of companies and individual market sectors and, as a result, can be affected by any number of both internal and external factors.

If you hold shares or investment funds it’s easy to obsess about short-term performance, especially given how easy it is for you to access the latest values at the touch of a button.

For a short-term investor, the stock market can be a highly risky place to hold money, and watching the value of your savings move up and down daily can be highly stressful.

The key point to remember is that you should consider investing as a long-term undertaking, because over periods of 10 years or more, equities generally outperform cash.

For example, according to a Brewin Dolphin study, an investment in the FTSE All-World index at the end of 1996 would have grown by 360%  by March 2023 assuming you reinvested all dividends.

You can control the amount of risk present in your investments

Risk is all about the chance of your investments declining in value.

The amount of investment risk you’re able to accept in order to meet your investment goals depends on a range of factors. These include how long your money will remain invested and your personal tolerance to the chance of losing money in the short term for the benefit of long-term gain. You may well have seen the latter referred to as your “attitude to risk”.

Low-risk assets, such a fixed-interest and government bonds are seen as safe investment options but typically offer less growth potential.

Higher-risk investments can provide you with a greater chance of positive investment returns but, at the same time, are more volatile with a higher chance of declining in value.

It’s important to bear in mind that your attitude to risk is likely to change over time. When you’re younger, with a long investment time frame, you can take on greater risk, comfortable in the knowledge that there is time for volatility and market upheaval to work their way through the system.

As you approach retirement, you may want to accept less risk as you start looking to protect the value of your assets.

Dealing with the challenges of volatility

As an investor, one of your key tasks should be to focus on risk and try to tune-out the ongoing media focus on market volatility.

In reality, unless you’re selling investments, volatility is not a big problem for you. In fact, it can actually be beneficial. 

This is because falling share values enable you to purchase those shares at a lower price in the expectation that their value is likely to increase over time. 

You can also mitigate against market volatility by diversifying your investments across different asset classes and market sectors. This is because of the variety of external factors that can affect share and fund values and the fact that different markets react differently to different events.

For example, manufacturing companies can struggle at times of high inflation because of the increased cost of raw materials. Conversely, companies that provide essential consumer goods are less likely to see a downturn in profits.

Finding the correct level of risk can be a balancing act

Investments at each end of the risk spectrum can create different issues that can affect your investment performance. 

For example, while there can be good reasons for holding some cash in your portfolio, especially as you get close to retirement, holding too much in cash and lower-risk investments can suppress your growth potential and leave you falling short of your financial goals. 

In contrast, having a portfolio of high-risk speculative investments can increase the chances of losing money. 

In reality, the best portfolios will tend to hold diversified investments with different levels of risk that are spread across different markets as sectors to smooth your returns.

The importance of regular reviews

As you’ve already read, your investment strategy should not be set in stone.

The famous economist, John Maynard Keynes, once said: “When the facts change, I change my mind”. In the same way, your investment strategy should change as the facts driving its composition change. 

For example, you are likely to go through many key life milestones while your money is invested – from getting married and having children to planning for your retirement. 

The key point is to ensure you review your investment strategy, and the financial plan it forms part of, to ensure they remain appropriate and designed to help you achieve your goals. 

Get in touch

If you have any queries regarding your own investments, or any other financial planning issue, please get in touch with us. 

Please note

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance

This article is for information only. Please do not solely rely on anything you have read in this article and ensure that you conduct your own research to ensure any actions you may take are suitable for your circumstances. 

All contents are based on our understanding of ATO and HMRC legislation, which is subject to change.