The difference between volatility and risk

One of the most common mistakes investors make is to confuse volatility with risk.

At best, it leads to unnecessary stress and worry, and at worst it can lead to heavy financial losses. It is therefore vital that investors understand the difference between the two.

What is volatility?

At its simplest, volatility is a way of describing the degree by which share price values fluctuate. In volatile periods, share prices swing sharply up and down while in less volatile periods their performance is smoother and more predictable.

Risk, on the other hand, is the chance of investments declining in value. How much investment risk you’re able to take on depends on a range of factors, most notably how long you’re investing for.

Interpreting volatility as ‘risk’ is a misjudgement often caused by watching your stock portfolio too closely. In one sense, this is perfectly understandable. The stock market is a risky place to be in the short term, and watching the value of your life savings jump around from day to day can be gut-churning.

Taking the long view

Investing in the stock market requires a long-term perspective. History shows that over periods of ten or more years, equities generally outperform cash.

For example, our analysis shows that if you had put £100 in a cash account at the end of 1996, it would have grown to £115 by March 2023, after adjusting for inflation¹. That’s a gain of just 15%². In contrast, if you had invested £100 in the FTSE All-World over the same period, it would have increased by 360% to £460 before fees. This assumes dividends were reinvested and is adjusted for inflation.

Source: RBC Brewin Dolphin / Refinitiv Datastream. Returns are based on an initial investment of £100 over the period 15 December 1996 to 15 March 2023 with the assumption that all dividends or income paid out are reinvested.

In that time, we have endured the recession of 2001, the market bottoming out in 2003 and the financial crisis of 2008/9, when markets were swinging up and down by 4% or 5% a day. More recently, in March 2020 stock markets suffered huge crashes as the spread of Covid-19 led to fears of a global recession.

Investors who took a short-term view may well have made a loss. The key is to remember that, over the long term, share price values tend to bounce back.

The benefits of volatility

Volatility can be a powerful force for good because these wild swings work both ways. For example, our research shows that missing the market’s five best days between December 1971 and April 2023 would have led to a 44% lower return than if you had remained invested throughout. Missing the best 20 days would have reduced returns by a staggering 84%. So, while stock market volatility may be stressful, history shows it is better to stay invested in bumpy times because long-term returns typically outweigh short-term losses.

Getting some smart advice can help you invest objectively and rationally, and avoid knee-jerk reactions. By staying calm and focusing on the long term, you’ll reduce your chances of making a costly mistake.