The Difference Between Risk and Volatility

In the world of Wealth Management, investments are generally categorized by their level of ‘risk’, and investors by their ‘risk tolerance’. While the default assumption is higher risk investments carry a bigger chance of losing money, this is not actually always the case.

What is risk?

Risk can be a very subjective word, as there are different types of risk. When referring to investments, most investors typically view risk as the potential or likeliness of losing their money. This generally refers to seeing a permanent decline in the value of their investments, or it no longer being liquid and them having access to it.

To investment industry regulators, risk is almost exclusively defined and categorized based upon volatility, or how much the investment can go up or down in value from year to year (also referred to as standard deviation). As of September 2017, mutual funds and ETFs in Canada were categorized for risk ratings based on their standard deviation over 10 years, on a scale as follows:

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Is standard deviation a good determinant of risk?

The problem with basing risk ratings solely on volatility (or the investment’s standard deviation) is simply that not all volatility is bad.

Consider an investment with the following sequence of annual returns:

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This investment would inevitably end up being rated as “high risk” due to its wide range of returns, resulting a standard deviation of well above 20. However, an investor that held this investment over the course of the full 10 years would have had very little chance of losing much (or any) of their money. Instead, they would have experienced great growth in their investment over that period of time.

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Low volatility can also present investors with risk. Again, consider an investment with the following sequence of annual returns:

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While this investment would have a standard deviation that would classify it as a “low-medium risk” investment, an investor that held it for the full 10 years would have lost nearly 25% of their initial investment. Although the following real-world example is a fund that is rated low-medium risk, it still demonstrates how “lower risk” funds can lead to losses over the long-term (the blue line is again the value of the fund being referred to).

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Risk management

To further mitigate the volatility of “high risk” investments, negatively-correlated investments can be held together. This means when one investment is going up in value, the other is generally going down, and vice versa. When held together, the resulting portfolio can still have positive returns, but with a lower level of overall volatility than the individual investments

Other useful metrics

While no rating system is going to be perfect, categorizing risk solely based on volatility can be argued to be an incomplete and somewhat flawed system. Many other performance metrics are readily available for most investments, and incorporating some of these would give a more fulsome and accurate representation of risk. Some of these other metrics include:

• Upside capture (ie. if the market is up 10% and the investment is up 12%, it has a 120% upside capture)
• Downside capture (ie. if the market is down 10% and the investment is down 8%, it has an 80% downside capture)
• Long-term returns (is an investment really high risk if it has provided high returns over a 10+ year holding period?)
• Best and worst 3-month returns
• Maximum drawdown (biggest decline from peak level to lowest point)

The value of Professional advice

Recent regulations in the investment industry have created the requirement for advisors to Know Your Product (KYP). Fulfilling this requirement involves looking beyond an investment’s volatility-based risk rating to determine the true level of risk of an investment, not just how much it has historically changed in value from year to year. Further to that, advisors can do analysis of not just investments individually, but at an overall portfolio level, and can seek investments with negative correlations to help create a portfolio with higher potential returns along with lower volatility.

If you want to understand the actual level of risk in your portfolio, or potentially add some exposure to investments with higher levels of “good” volatility, please reach out to me at dennis.rubeniuk@endeavourwealth.ca.‍

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This information has been prepared by Dennis Rubeniuk who is an Investment Advisor for iA Private Wealth Inc., and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this, post comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors.

iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Canadian Investment Regulatory Organization. iA Private Wealth is a trademark and a business name under which iA Private Wealth Inc. operates

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