The famous daredevil Evil Knievel once said: “Risk is good. Not properly managing your risk is a dangerous leap.”
While he was talking about jumping a motorbike over a line of school buses, the sentiment still holds true when thinking about investments.
Without exposing your wealth to some level of risk, you may not be able to achieve as much growth as you otherwise could. But, adopting too much risk or the wrong type of risk could mean there is a greater chance to lose money, ultimately making it harder to reach your long-term goals.
That’s why finding the right balance and knowing how to correctly assess the level of risk in a given investment is crucial. Unfortunately, many investors find this difficult because they don’t know the difference between market volatility and risk.
Often, people use these two terms interchangeably. But there is actually an important distinction between them, and understanding this could help you make more measured decisions about your wealth.
Read on to learn about the difference between volatility and risk, and why it’s so important.
Volatility simply describes the movement of an investment
The term “volatility” describes fluctuations in the value of an asset, index, portfolio or any other kind of investment.
The word can apply to an upwards movement, as well as a drop in value, and it is not necessarily a bad thing. For example, during a period of volatility when prices are fluctuating, you could see the value of certain investments increase.
Despite this, investors tend to perceive volatility as a negative factor in terms of investing and assume that it is always a cause for concern.
Indeed, you may have been nervous about the volatility of the last few years. Global events such as the Covid-19 pandemic and the war in Ukraine caused uncertainty and the value of your investments may have dropped as a result.
You might have assumed this was a threat to your financial plan but that is not necessarily the case, and it is important to always consider these movements in a wider context. The market downturn was similar to previous market fluctuations, such as the 2008 financial crisis, the dot-com bubble, or even the Wall Street Crash, for example.
Global markets regularly experience these big upsets. In many cases, they bounce back and investors still achieve long-term growth.
When Covid-19 swept across the world, for instance, the Dow Jones and S&P 500 experienced their biggest weekly declines since the 2008 financial crisis in late February 2020. Even so, the markets had returned to their pre-pandemic levels by May 2020.
Consequently, volatility does not necessarily equate to risk because investors may still see long-term growth and reach their financial goals if they simply wait until markets bounce back.
If you want to determine the level of risk you are exposed to, you must consider your own financial goals as well as the ups and downs of the market.
Market volatility becomes risk when it gets in the way of your financial goals
Whenever there is a period of short-term market volatility, many investors panic because they feel that the risk has increased too. They may think that, if prices are dropping, holding those investments is riskier than it was in the past, when prices were rising.
Yet crucially, market volatility only equates to increased risk if it makes it harder to reach your financial goals.
If you have no plans to sell investments now or in the near future, short-term volatility does not necessarily create risk. You may plan to hold those investments for another 20 years, for example, so the critical question is whether the value is likely to increase in that time frame or not, regardless of short-term movements.
Indeed, historical stock market data shows that it often will. For example, according to figures from the London Stock Exchange, the value of the FTSE 100 almost doubled between 6 April 2003 and 6 April 2023.
This is despite several considerable market upsets in that 20-year period, including the 2008 financial crisis. Historical data from the London Stock Exchange shows that the FTSE 100 dropped 34.86% in February 2009. However, by February 2011, markets had recovered, and the value of the FTSE 100 was rising again. So, for example, if had you planned to sell your investments sometime between 2008 and 2010 and use the funds to purchase a holiday home, this short-term drop in value may have affected your goals.
However, if you held your investments for the full 20-year period and then sold them to fund your retirement, the level of risk is different. That volatility, in all likelihood, wouldn’t have created much risk because, by the time you came to sell your investments, the markets would have recovered and you would still have been able to fund your desired retirement.
In this instance, volatility may have even been a good thing because it would allow you to invest more at a lower price when values dropped. So, you may have achieved greater growth during the period.
This demonstrates that two investors can have a completely different level of risk depending on what their goals are, even though they are both affected by the same period of market volatility.
Bear in mind that past performance is not a reliable indicator of future performance.
Keeping your goals at the centre can help you navigate market volatility
Understanding this important distinction between volatility and risk can help you remain calm and think clearly in the face of market noise.
It’s easy to let warnings about market fluctuations worry you, especially when you see the value of your investments dropping. So, before making any decisions, it can be useful to revisit your goals.
Consider whether this period of volatility will genuinely affect your ability to reach your financial goals. In many cases, particularly if you are planning for the long-term, you may find that it doesn’t, and you don’t need to make any changes to your strategy.
Working with a financial planner to set clear goals and assess how different factors may affect them can be useful here, especially if you are prone to making reactionary decisions in uncertain times.
Flying Colours was established in 2015 by Guy Myles, CEO and founder of Flying Colours, he is also one of the co-founders of Octopus Investments.
Flying Colours was created to offer consumers a way to access financial advice and investment management without compromising the quality of advice and investment solutions needed to help clients reach their goals.
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