There is often confusion about the relationship between risk and volatility. They are not the same thing, yet many investors use them synonymously.
As one financial writer explains, “Risk is the chance of a permanent loss of capital. Volatility is unpredictably both high and low around a long-term trend line.”
For example, an investment may have low risk of permanent loss yet still have high volatility with dramatic price swings.
This is why volatility can present opportunities for investors. Howard Marks, an investor and writer at Oaktree Capital Management, notes, “As an asset declines in price, making people view it as riskier, it becomes less risky (all else being equal)”.1
Of course, higher volatility can mean higher “potential risk”, as our regulator points out.2
One common way to mitigate risk is through diversification. Owning one stock has greater risk—chance of permanent loss—than owning an index of many stocks like the S&P 500.
While company failure causes permanent loss, normal price fluctuations are expected in markets.
Thankfully, volatility changes over time. The above JP Morgan chart3 reveals how over the short-term stock market volatility is high, while over the long term it is lower.
Therefore, time frame matters greatly in investing.
In summary, risk and volatility are related but distinct concepts. Investors can reduce risk through diversification and temper volatility through long time horizons.
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Sources:
1. “Risk Revisited”, p 12. 2014-09-03-risk-revisited
2. “Investing Basics: Volatility” (FINRA). Volatility
3. "Guide to the Markets" (3Q 2023), page 65. https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/