In olden days of elementary school, teachers would talk about putting on our thinking caps. I ask you to do that today and consider the relationship between risk and volatility. These are incredibly important concepts for you to understand if you are a do-it-yourselfer, and for you and your adviser to discuss if you use one.
Risk is a measurable possibility of losing value or not gaining value. Volatility is the tendency of an investment to rise or fall in value within a given time period. Most people probably think the two go hand in hand. If the return or value of an investment does not fluctuate in the short term, it must be low risk, right?
First, every single thing on God’s green earth carries some risk of one type or another. When you deposit your check into your local bank, you are lending the money to the bank and expecting it to give it back to you the instant you want it again, by check, debit card or showing up at the teller window.
Not many banks in our country fail, but some do. The FDIC guarantees most deposits up to its account limits, but the FDIC gets its money from its member bank assessments. Behind the FDIC is probably the backstop of Congress voting and the president signing an act to guarantee more resources if it were to run out of reserves. You do not have to fear about your safe money, but consider another type of risk.
Right now the Federal Reserve Bank decrees that short-term safe money should pay almost nothing in interest. This is to force you to invest in other places, to start a business or to spend it so someone else can get a buck of profit and hire someone. It is not working, but that is the idea and they are sticking to it.
Since most things you buy are going up in price, you have a great probability that you are losing value and not gaining value. If you have a lot of that asset (safe money), you are almost guaranteed that you will lose every year until the Fed gives up or declares victory or both. But this risk of loss is very steady and has almost no volatility with it.
I met with relatively new clients yesterday. They wanted to invest very conservatively, and now they have a six-month track record. Early on, in June, their account had dropped by 1 percent to 99 percent of starting value. Now they have a net gain of 5 percent. They experienced some short-term volatility. But now they understand their risk of permanent loss may be less than they thought. They could be guaranteed to be losing slowly and surely (with no volatility) or they can accept some volatility with a higher probability of gain.
Page 2 of 2 - All of life – every decision – deals with probabilities. The fact that investment results are uncertain is the only reason one can make greater gains in the financial markets than from a guaranteed rate investment where someone else takes all the risk for you. Risk and volatility therefore can be a great friend if you understand and use them in moderation. But please don’t fool yourself by thinking any valuable asset is risk-free.
(The above discussion is intended for the general readership of this column and is not intended to be specific advice for anyone. Past performance is no guarantee of future results.)
Ron Finke is president of Stewardship Capital in Independence. He is a registered investment adviser. Reach him at firstname.lastname@example.org.