People often confuse risk and volatility. This confusion leads them to make poor financial decisions. Decisions that will negatively impact their long-term financial situation. Here I will be using terminology that helps me better understand and practice discipline.
Volatility
By volatility, I am referring to price volatility. Volatility refers to rapid changes in the price of something. Suppose a stock is selling for $10 in the morning, $14 at noon, and $7 in the afternoon. That is volatility. The profitability of the company is not changing that fast. Just the value perception of the stock in the market is changing rapidly.
The price reflects how the market feels about the stock on any given day. The earnings of the company are not changing that rapidly. The price is reflecting the earning potential of the company. It is reflecting market sentiments of the buyers and sellers. This is volatility. Volatility makes great media stories. Headlines such as “stock skyrockets to whatever”, “stock plummets to whatever”, and “housing price increased by 30%” are click-baits. They attract attention to the content. This is how media makes money. This is what you should ignore.
Risk
Risk refers to the chance of something bad happening. If you drive without a seatbelt, your risk of severe injury is higher than if you wear a seatbelt. If you are driving at double the speed limit, the risk of an accident is higher. For my finances, I define risk to be the long-term impact of negative forces on my earnings. Note that I said “long-term”. What could be a bad thing? Price of oil doubles. Supply chain is disrupted. An incompetent board makes decisions that are detrimental to the long-term profitability of the business. These are risks that could impact the long-term profitability of the business and my investment.
Examples
Let’s look at real life examples. I consider a good PE ratio to be less than 20. Tesla’s PE ratio is 452 on Oct 15. Toyota’s PE ratio is 9.52. This could mean Tesla is overpriced by a lot. This is risk. If the price dropped to PE 20, then I would only be able to sell the $864 dollar stock for a few dollars. Note that a full analysis is required to analyze a stock. I am just using P/E for illustration.
Compare this with Toyota. It is the largest and globally the most popular brand. It has thousands of patents, global distribution network, cutting edge research capabilities, and large global manufacturing capacity. It is a global giant. The stock seems to be selling at a reasonable price. It appears to be less risky than Tesla.
Compare this with S&P500. This index contains America’s 500 largest companies. It includes Google, Amazon, Facebook, Coca Cola, and other global brands. What is the likelihood that all of them will crash to a fraction of what they are worth now? Pretty unlikely. Yes, they will face volatility but over the long term, they are expected to do well. The risk of losing your money is lower with S&P500 is lower than owning only Toyota or only Tesla or both Tesla and Toyota.
What happens to most people who confuse risk with volatility. They buy at the wrong time and sell at the wrong time. This is the exact opposite of what an investor should be doing.
