Volatility is not the same as risk

Volatility is not the same as risk

Over the last several months, a common refrain in this market is that volatility is quite high. If one day the stock market is up, the next day it’s down by an equal or larger number. By their very nature, financial markets are volatile reflecting the news and developments happening every day. A mishap here or there can cause the market to swing wildly, up or down.

But is volatility the same as risk?

Financial concepts have us believe that volatility is the same as risk, and end up costing us money. Sure, volatility makes assets such as equity swing more wildly than other assets. An understanding of the concept of risk will give us a true picture. Risk is usually seen as a probability of loss say in any asset class. If you lose your investments, then the asset is risky. But in stock market parlance, volatility is also looked at as risky. Warren Buffett explained the concept of volatility and risk in his 2014 annual letter to his shareholders, and how mixing these concepts is costing investors.

 

“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency denominated instruments are riskier investments – far riskier – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray”

 

Volatility is an inherent characteristic of equities in the short-run. But that does not imply risk as most people mistakenly think and as explained by Buffett, who adds that not investing in shares and holding currency instead is far more riskier in the long run.

“It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing power terms) than leaving funds in cash-equivalents.

That is relevant to certain investors - say, investment banks - whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in shorter term investment tools.

 

For the great majority of investors, however, who can - and should - invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, can prove far less risky than dollar-based securities.”

 

Over decades, such as 10 and fifteen years, equities can provide inflation-adjusted reasonable returns for investors. A recent Morgan Stanley report said that equity has delivered the best returns over 5-, 10-, 15- and 20-year periods in India, compared to gold, real estate, fixed deposits, et al. Over a 20-year period, equities returned 12.9 percent, gold 8.4 percent, bank fixed deposits 5.5 per cent and property 6.2 percent. (Source: Morgan Stanley) Cash in hand would be less volatile in the short run than stocks. But understand that volatility in stocks is not the same as risk.

 

Instead, real risk is the loss of purchasing power that your cash in your wallet would be left with.

Buffett says holding cash is riskier than a stock portfolio built for the very long run.

Happy Investing

Source:Icicidirect.com