Risk vs Volatility

Risk is something that even a child understands, but few can define. As investors, we are not interested in its academic definition. What matters to us is what it means to us. And how is volatility related to risk, if at all.

For a moment, think of a person’s lifetime. If risk is the chance that the person may die (an irreversible process, as far as we know), then volatility is the varying condition in his/her life. Sometimes their life is merry and rich, both materially and psychologically. At other times, life is in the doldrums, and it seems as if there will never be a better day. But it just “seems”, there is always a possibility of a better day. But after death (or risk turning out to be real), there are no other days.

Now you can easily guess the application of this example to investing. To an investor, risk is the chance or probability that an investment (and by definition the business behind it) sinks irreversibly. It becomes zero, with no possibility of revival. Therefore, we seek to avoid risk as much as possible.

Volatility, then, is the highs and lows of the market. As long as the foundational elements are strong, short term ups and downs do not affect a business or a stock. As a matter of fact, even long term ups and downs do not really matter for a stock, if the fluctuations have no effect on the real business.

As we stated, we want to avoid risk. Volatility also does not seem very appealing. Who wants to deal with the ups and downs (especially the downs) every day. However, this is where opportunity lies. Humans dislike uncertainty, and volatility breeds uncertainty. Therefore, shares whose prices are volatile are considered “risky” by the marketplace. This is complete nonsense, as you can tell from the difference between risk and volatility above.

“Avoid Risk, Embrace Volatility”

Good investors learn to love volatility and profit from it. Buy shares when they are priced unnaturally low. Sell when they are wildly high.