Understanding Risk versus Volatility

Risk versus volatility. It is unfortunate that Modern Portfolio Theory uses the term volatility interchangeably with the term "risk". Investment professionals assist in this confusion everyday.

Risk in a portfolio sense should describe the danger of losing money. Thus to bet one's fortune on a single speculative stock is inherently risky. There are a number of reasons why risk exists in this situation. There are a number of steps one can take to reduce the overall risk of loss.

Volatility, by comparison, relates purely to the degree of fluctuations in the price of a security (or portfolio). There are a number of factors determining how volatile a security will be, but risk of loss is not the main one. Some of the main determinants are uncertainty of future prospects, the level of company gearing and hence sensitivity to interest rate movements, cyclical earnings, etc. Thus a speculative exploration company using its last cash to drill a prospect which is going to either quadruple the company' s worth if successful or cause it to be virtually worthless if not is likely to be highly volatile. In this instance it is also a high risk investment. A company like Woolworths with a predictable earnings stream is low risk. It also displays a low level of volatility most of the time.

Portfolio Theory teaches that the more volatile an asset is, the greater is its degree of risk and the higher the expected return to be generated. Any thinking investor observing the Australian market can appreciate that the theory is well intended but unreliable. You merely have to consider mining shares in relation to industrial shares over most decades. Mining shares are inherently more volatile than industrial shares for a number of very good reasons. Yet their returns on average for most of the 20th Century were woefully lower than industrial shares and for equally very good reasons.

The problem of investing as your "risk" profile

Personal emotional tolerance to risk and volatility determines how you will react to news. You may cause losses for yourself by reacting emotionally to unexpected loss.

A very low emotional tolerance to share price volatility means you are more likely to be prone to the classic trap of buying at the highs and selling at the lows. Some investors cannot bear the thought of accepting a loss on a single investment. They hang on, hoping the security will magically improve, often long after the reason for holding the company has gone. To the cynics, a "long term investment" is a short-term investment gone wrong. You must "enjoy' your failures along with your successes.

You can measure your risk profile and compare it with the average investor by completing a web-based questionnaire.

But what do you do with it? The average financial adviser selects investments that reflect your risk tolerance level. But for a low risk tolerant investor, this means avoiding the sharemarket altogether, ensuring an inferior long-term return and probably a failure for your capital to last your lifetime.

This is because a financial adviser is more likely to receive a complaint for putting you into sensible long term investments that go wrong in the short term, than they are for ensuring you fail to have enough capital in thirty years time, by which time the adviser will have retired from the business.

I have undertaken over the years the challenge of increasing the emotional risk tolerance of my clients instead. Raising awareness and knowledge of the natural cycle of fluctuations in shares (before it happens) helps. Trusting a professional and outsourcing the day to day responsibility puts the worry on to the professional. When asked how I slept at night with so much responsibility for other people's money I'd reply "Like a baby." Then after a pause. "Sometimes I wake up at two in the morning for no apparent reason and start crying."

It hasn't always worked. Investors who appear to have high emotional risk tolerance and experience suddenly do not show any risk tolerance when things turn a little sour. As a rule, investors who have tried to second guess me most of the time and lack patience have caused more grief than investors lacking risk tolerance. I now try to avoid taking on clients with these characteristics.

A surprising number of women turn out to be very good clients precisely because they have more patience and trust in the professional.

As your comfort zone increases, gradually increase your risk exposure. As market cycles take several years, it may well be that by the time you are well into retirement you will be more comfortable with the majority of your assets in shares. You may then have the dilemma facing many experienced investors whose emotional risk tolerance in retirement exceeds their financial risk tolerance.

For some reason, otherwise low risk tolerant people also tend to gamble small amounts regularly. Their savings are limited to bank deposits, but then they play pokie machines or buy lotto tickets (or occasionally speculative shares) in an attempt to obtain a get-rich-quick fix.

Your risk tolerance will not be the same throughout your life. An accumulator with a reliable large income is in a much different position to tolerate short term risk than a retired investor for whom preservation of existing capital is more important. Your risk tolerance will be affected by whether you are:

Young or Old

Rich or poor

Risk tolerant or Inexperienced

Gambler or Investor

Healthy or unwell

There is no simple answer to this question.