Risk vs. Volatility: What Every Investor Should Know

While "risk" and "volatility" are sometimes used interchangeably, they don't mean the same thing. The two are sometimes related, but understanding the difference between risk and volatility is crucial for investors to make smart decisions.

In particular, understanding how risk affects certain investable assets can help you better match your investment portfolio to your investment goals, while understanding volatility can help you better match your portfolio to your risk tolerance (conservative, aggressive, or moderate), particularly as it relates to weathering market downturns.

Here, we'll unpack how risk and volatility differ in some ways while intertwining in others.

What is risk?

In the investing world, "risk" generally refers to the possibility that an investment will fall short of its expected value. In many cases, that's monetary loss, but it could also be situational losses or not attaining a desired outcome, like how liquidity risk means that it's difficult to turn your investments into cash quickly, which could cause issues like having you miss out on other buying opportunities.

All investments carry some degree of risk. Even fixed annuities, which have a guaranteed rate of return, still have the potential to fall through, such as if the insurance company behind the annuity goes out of business, along with some other backstops not working as intended. Generally, though, some investable assets that are commonly considered to be low-risk include

• Series I savings bonds
• Treasury bills, bonds, and notes
• Highly-rated corporate bonds
• Certificates of deposit (CDs), particularly short-term CDs
• Fixed annuities
• Money market funds

These are often considered low-risk because there's little chance of losing the money you put in, but that often comes at a cost, because risk and return are correlated. This is sometimes referred to as the risk-return tradeoff, which defines that the higher the risk, the greater the chance for a high return usually. The lower the risk, the lower the chance for a high return. Although riskier investment options can be tempting, only folks who can sustain large financial losses should invest in high-risk assets. 

High-risk investments often include: 

• Individual stocks
• Hedge funds
• Private equity funds
• Cryptocurrencies
• Real-estate investments, including REITs

The level of risk can still vary among these investments, such as how some well-established companies might be considered to have lower risk than ones that recently had an IPO, for example. Still, one reason individual stocks are risky is that you're putting all your eggs in one basket, a strategy that most stock traders and financial consultants advise against, especially if you're a beginner. Beginner investors are usually best off diversifying their portfolios with a range of assets across multiple market sectors.

By diversifying your investment portfolio, you're lowering risk to any one asset and benefiting from increased market exposure. This can also help with volatility, as you're balancing out the ups and downs of investing by holding a diverse range of assets.

"Through intelligent portfolio building and diversification, investors can create a portfolio of risky assets with an aggregate volatility that is lower than any of the individual securities," says Nathan Wallace, founder and head of investment management at Grey Fox Investors. "The key here is to buy securities with the goal that when one asset is performing poorly, another asset will pick up the slack through positive performance."

Whether investing in a riskier investment is a good idea can be impacted by your time horizon. Younger investors are generally better candidates for high-risk investments since they have more time to recover from potential losses. The reverse is that older investors nearing retirement age do not have time on their side and are often better off with low-risk investments with less volatility. 

Types of risk

There are many different types of risk that investors should consider when assessing the likelihood of losses or opportunity costs. Some common ones include:

• Market risk: Investment risks fall into two main categories: systemic or unsystematic risk. Market risk is systemic risk, which refers to the possibility that an investment will lose value based on the market's performance, generally without regard for the underlying fundamentals of an asset. For example, a company may be highly profitable and its stock could be doing well, but there's market risk that investor fears of a recession cause a stock selloff, causing the stock of that highly profitable company to drop too. In contrast, unsystematic risk (aka specific risk) refers to the possibility that an investment will lose value based on the performance of a particular industry or business. 
• Credit risk: This is the risk that a borrower will be unable to meet its debt obligations, i.e., that it will default. Investing in corporate bonds of companies with high credit risk, for example, increases the odds that you won't get your money back because the company may be unable to repay bondholders.
• Liquidity risk: A systematic risk associated with how easily you could turn your investment into cash. Illiquid assets like real estate or cryptocurrencies hold a higher liquidity risk. If you're unable to sell an asset when you want, you might miss out on a sudden opportunity or face costs like having to put expenses on your credit card if you're short on cash.
• Exchange-rate risk: Sometimes called a currency risk, an exchange-rate risk occurs when you invest in assets from a foreign country. If the value of the foreign currency changes, it may lose value. For example, if you invest in stock in France and the euro depreciates in value vs. the U.S. dollar, you may lose money even if your stock is appreciating in value. That's because when you sell the stock and convert from the euro to the dollar, the lower euro value means you get fewer dollars back. 
• Commodity risk: The value of a commodity investment may fall if the underlying physical good were to become less valuable. Commodities, like agricultural products, are impacted by uncontrollable factors like weather or other natural disasters and can face high, unpredictable risks. The best commodity trading apps offer multiple investable tangible goods, including soft, precious metals, and crypto. 
• Country risk: A systemic risk determined by the financial and economic health of the country distributing your investment. Assets like stocks, bonds, futures, etc., that are tied to a country's financial well-being are susceptible to this risk.
• Business risk: Risk resulting from how successful a business is based on whether the company is profitable and generating sufficient revenue to cover operational expenses, like office rent, administration costs, employee salaries, etc.  
• Operational risk: A subsection of business risk associated with daily business operations, such as human errors, the chance of fraudulent activity, or issues resulting from internal processing failures. 
• Interest rate risk: A systematic risk that's a subset of market risk, associated with an investment's value based on the economy's interest rate. Interest rate risk is more likely to directly affect bondholders than stockholders, as rising interest rates may cause bond prices to fall. 
• Inflation risk: A systematic risk that's also a subset of market risk, which causes prices throughout the market to move upward. Assets, such as bonds with a fixed rate return, can lose purchasing power and decrease in value if inflation were to make a significant leap. 

What is volatility?

Volatility refers to the extent to which the price or value of an individual asset or sector of the market fluctuates over time. In short, it's a measure of how frequently the price or value goes up or down and the magnitude of those swings. Increased volatility can result from a wide range of risks, such as geopolitical events, market attitudes, liquidity concerns, news reports, and natural disasters. 

In and of itself, volatility isn't necessarily negative. Large swings in prices may be unsettling to some investors, but if the long-term trend is still up, then it doesn't necessarily matter how much volatility there is. On a more technical level, though, high volatility can potentially affect issues like returns from dividends and capital gains, but for the most part, it doesn't have to make a big impact on those who buy and hold investments. Think of how in a football game, it doesn't necessarily matter if your team goes up by a touchdown, then falls down by two scores, before coming back and winning at the end. There's volatility in the score, but the end result is what really matters.

Just like risk, all investable assets have some degree of volatility or at least potential for volatility. However, some investable assets provide more market stability than others. 

Low-volatility investments often include: 

• Highly rated corporate and municipal bonds
• Treasury bonds, bills, and notes
• CDs
• Gold and silver commodities

Long-term investors don't have to be as concerned about market volatility, in most cases, as the price of the investment may even out — and ideally go up — over time. Short-term investors, on the other hand, are more vulnerable to high volatility. 

High-volatility investments often include: 

• Cryptocurrencies
• Exotic currency pairs
• Energy commodities
• Agricultural commodities

The cryptocurrency market is regarded as one of the most volatile markets, as decentralized digital currencies like bitcoin, ether, and dogecoin are easily influenced by investors' overall attitude toward the coin or token. Therefore, crypto assets are constantly fluctuating in value. 

Other assets like stocks can have varying degrees of volatility. As a whole, the stock market generally has more volatility than bonds, but certain stocks may be more stable than others.

Measuring volatility

There are two main ways of looking at volatility:

• Historical volatility: This measure of volatility is based on an asset's previous price patterns over a set period of time. As the name implies, it is background-looking and not necessarily a good predictor of how volatile an asset might be in the future.
• Implied volatility: This type of volatility, sometimes called projected volatility, is used to forecast how much a certain investment will fluctuate during a set period of time in the future. Implied volatility is often calculated based on options prices, which provide insight into the price movements investors think an asset is poised to make. Generally, implied volatility will drop in bullish markets. 

Digging deeper, there are common metrics used to calculate historical or implied volatility, such as:

• Beta: Measures the volatility of an individual investment or specific market sector in relation to an underlying benchmark or overall market performance. Wallace states, "A beta of 1 means that when security A goes up 1%, security B will [be expected to] go up 1%, while a beta of 1.5 means that when security A goes up 10%, security B would be expected to rise by 15%." In other words, an asset with a beta of more than 1 can be expected to have above-average volatility.
• Standard deviation: Used to measure historical volatility, based on how much an investment varies from its average annual rate of return. The higher the standard deviation, the more volatility. So while an asset might have a high average annual return of, say, 10%, a high standard deviation could mean that some years you get a 20% return and some you get 0%, as opposed to consistently staying around 10%.

There's no need to worry about calculating these metrics if you're not a math wiz, since most risk metrics are already reported by professional research organizations and some financial institutions.

Relationship to risk

Although volatility and risk are not interchangeable, they're related. Usually, a high-risk investment is also highly volatile, as it can go up or down a lot. However, high volatility doesn't always imply high risk, especially when taking a long-term view. For example, stocks are often volatile in the short term, but over the long run, diversified stock investing is generally considered to be a relatively safe way to invest for long-term goals like retirement. If you can endure high volatility, you might be rewarded in the end. 

However, there's a risk that high volatility causes investors to make irrational decisions. For example, if you see stocks falling rapidly, you might get scared and sell your investments, thereby locking in losses. Instead, if you could have waited out the volatility, you might have seen those asset prices recover.

Also, volatility can create certain types of risk in certain situations. For example, a retiree with a highly volatile portfolio could face liquidity risk in the sense that they might not want to sell assets during high volatility periods when prices are down, otherwise they'd lock in losses. Yet by not being able to sell during that down period, they could face a cash flow problem. That's why retirees' risk management strategy often involves incorporating low-volatility assets.

Key differences between risk and volatility

Risk and volatility sometimes go hand in hand, but there are a few key differences. Namely, there are some differences regarding:

Timing

Risk can be both a short-term and long-term issue, depending in part on the type of risk, while volatility tends to be more about short-term fluctuations.

Permanence

The focus of risk is usually on the potential for permanent losses, whereas volatility implies short-term price changes that aren't necessarily permanent. A volatile asset could be down a lot one day but then recover the next, whereas an issue like credit risk could mean that the asset never recovers due to an issue like bankruptcy.

Control

While both risk and volatility often involve forces outside an investor's control, risk is often seen as more of an internal issue within a portfolio that an investor can control, while volatility is something that's more so bound to happen. For example, an investor could create a diversified portfolio that helps limit market risk due to having assets that tend to move in uncorrelated directions. 

However, volatility isn't always as easy to control, as even having a diversified portfolio doesn't mean that it's immune from volatility, since much depends on the short-term behavior of other market participants.

How to assess and manage risk

There are several ways to assess and manage risk, particularly in the context of building an overall investment portfolio. Doing so involves focusing on:

Diversification

A common way to lower your risk exposure is through portfolio diversification. Holding both stocks and bonds, for example, can lower market risk, because if investors start to move away from stocks and into bonds, that could hurt stock prices and boost bond prices, so owning both can help balance out your portfolio. Also, owning many different stocks can help with various types of risk, such as if you own stocks of some U.S. companies and some foreign companies to balance country risk.  

"Investors can gain diversification by investing across regions, asset classes, sectors, and even exposure factors," says Wallace. He explains that beginners can start diversifying their portfolios by "taking the time to learn about the different correlations as the first step in your investment journey."

Asset allocation

Connected to diversification is asset allocation, meaning how you divide your investments into different types of assets. As mentioned, allocating to both stocks and bonds might decrease risk, for example, and you can also invest in other assets like some commodities, real estate, collectibles, and others to balance your portfolio in a way that matches your risk tolerance while accounting for your investment goals. If you're unsure what asset allocation is best for you, consider speaking with a financial advisor who can help you in this regard.

Due diligence

Doing your due diligence means thoroughly researching investments before you actually allocate money to them. For example, if you're investing in mutual funds, you don't want to just pick a random one, but instead you might review the fund's prospectus and look at reviews/ratings to see if the fund's risk management and investment objectives align with what you're looking for.

Long-term perspective

In general, taking a long-term perspective tends to decrease risk more than short-term investing. For example, stock prices can change dramatically day to day. Some days the market might drop by 2%; on others, it might rise by 2%. If you pick the wrong days, you could be in for steep losses. However, if you focus on the long term, you might be able to enjoy long-term gains, like how the S&P 500 has historically averaged around 10% gains per year.

How to manage volatility

Although volatility is often considered inevitable, although to varying degrees based on the investment, there are still ways you can lower volatility or at least make it more palatable. These include:

Dollar-cost averaging

You never know when markets are going to go up or down, so dollar-cost averaging can help you smooth out the impact of volatility. This means investing consistently over time, such as investing $100 with every paycheck into your 401(k). That way, if volatility occurs and your investments start falling in value, you're buying in at a lower price point, meaning you're bringing your average price of purchase down, which can help returns. This helps balance out times when you're buying into assets during upswing periods.

Rebalancing

Periodically rebalancing your portfolio, such as once per year, can help offset the impact of volatility, as you can get back to your desired asset allocation, rather than being thrown off course. For example, if you invest in 60% stocks and 40% bonds, but bond prices rise a lot while stocks fall, your portfolio value might shift to 45% bonds and 55% stocks. Rebalancing means selling some bonds and buying some stocks to get back to a 60/40 split. In doing so, you're also dollar-cost averaging to some degree; even though the volatility of stocks may have decreased their value in your portfolio, you're buying back in at a lower price point and can potentially benefit if they rebound.

Some investment platforms and financial advisors that get involved with portfolio management can automatically rebalance investments for you.

Staying patient and informed

Taking a long-term, patient view can help you manage both risk and volatility, as you're not reacting to short-term swings by panic selling. Instead, staying patient and informing yourself about what's happening in the market and why volatility may be temporary can help you avoid the negative aspects of volatility and stay in a position to benefit from possible future gains. Remember, even assets that have a history of gaining value often go through down periods, but these are often temporary.

FAQs about risk vs. volatility