How Are Volatility and Risk Related In an Investment?

Market volatility can be defined as the frequency and magnitude of price movements, up or down. The same can be applied to an individual investment; the more often the price swings and the more significant the change each time, the more volatile that investment is. High volatility can make a stock riskier, but it can increase the potential for gains as well as losses. That’s because price changes can go in either direction. For example, a volatile stock could shoot up by 20% one day, drop 5% the next day, and increase by 10% the following day, followed by another 5% drop. That looks frightening, but the result is a considerable gain for the stock’s owners. In contrast, a less volatile security might not gain 20% over several years.

One good definition of investment risk is the probability of loss relative to the anticipated reward. In many cases, a higher risk brings the prospect of a better reward. For example, if you buy stock in a start-up company with a brilliant idea but no actual sales yet, you are taking a big risk. If the concept proves itself, the business could take off like a rocket, and you could achieve wealth by being an early investor. Or you could lose your entire stake if the prototype fails and the company fizzles.

But analyzing the risk and the potential reward is often challenging and is not the same calculation across investment types. Real estate, for example, has different risk factors (and different volatility triggers) than securities.

Stock Market Volatility Can Offer an Opportunity for Rewards

People have a natural reaction to seeing their investments lose value; they want to cut their losses and bail out. But experts often say that’s not the best course of action. Analysts at the Schwab Center for Financial Research point out that over the last 50 years, the 12-month period following market losses of 20% or more are times of the largest gains. So if you exit during the valley, you could miss out on the next peak.

Instead of selling, take advantage of market drops to buy stocks you think have long-term value at discounted prices. Securities are long-term investments. Remember that if you anticipate a need for access to these funds soon, they should be in a less volatile investment option.

Real Estate Risk and Volatility is Measured Differently

Real estate risk is affected by different forces. Some of the elements are location, market demographics, sector health, asset class, and tenant behavior and fortunes. As with securities, some risks are foreseeable, while others are not.

Analyzing the risk of a particular real estate asset can be a complex calculation. For example, if you are looking at a Class A property in a prime location, the risk will be lower, but the price will be higher than for a Class C asset in a secondary neighborhood. The one offering more potential reward may depend on other factors like the economy, your ability to make improvements, and the demand for each.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. All investments have an inherent level of risk. The value of your investment will fluctuate with the value of any underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.

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