What is the difference between risk and volatility?
Posted by: Arti Bhargava on Jul 17, 2017, 10.06 AM IST
Shraddha's mother has just retired. She has always opted for traditional investments like post office deposits, fixed deposits and small saving schemes. She is conservative and does not want to take any risk with her hard-earned money.
To her, equity is to be avoided. But Shraddha has studied investments and tells her mother to keep a portion of her retirement corpus in equity. This will allow her corpus to grow and surpass inflation. But her mother thinks equity is volatile and therefore, risky. Is this a fair argument?
Risk refers to the possibility or chance of an injury, loss or hazard. In financial terminology, when Shraddha worries about risks, she is actually worried about the potential permanent loss of money. Volatility is merely how rapidly or significantly an investment tends to change in price.
By that logic, aren't PPF and other interest-bearing investments also volatile, as the return changes due to changes in interest rates? Have PPF rates always remained constant? Don't banks revise the rates offered on their fixed deposits? Equity prices are known to fluctuate sharply and regularly. But just because prices fluctuate does not mean there is a risk of loss.
Therefore, volatility does not imply risk of loss. Volatility simply refers to the price action. Some investments may be more volatile while others may be less.
So does this mean that Shraddha has no reason to be concerned about volatility? Of course, she does. If her savings bank account were volatile, she wouldn't want to use it for keeping funds that she may need to withdraw immediately.
Volatility matters if the money is needed immediately because she may be forced to sell and take a loss when the share price temporarily declines. This is the reason why short-term investments in the equity market are discouraged.
The equity market as a whole is much more volatile than a bank deposit, but that does not mean that Shraddha should avoid investments in the stock market. Just because an investment is more 'volatile' does not necessarily mean it is more 'risky' in the long term. One should know the potential for short-term volatility to affect the value of investments and plan investments accordingly.