July 5, 2021

3 min read

Investment and Life insurance

What is volatility in an investment?
… and why you should manage it.
Nicholas Flaherty Image

Nicholas Flaherty - Investment Strategist - FWU Invest S.A.

When choosing an investment product, such as a fund, you will have come across the term ‘volatility’, which is displayed in terms of a percentage i.e. 10%, 15%, 20%, etc. This figure represents the ‘riskiness’ of your investment, but in order to better understand this, let’s briefly talk about what ‘risk’ means when it comes to investing.


When we use the word ‘risk’ in normal everyday language, it usually comes with a negative connotation. We talk, for example, about the ‘risks’ of smoking, about the ‘risks’ of driving too fast, of eating unhealthily, etc. When it comes to the world of investing, however, risk is better described in terms of both a negative aspect as well as a positive one. Yes, it is about danger, but it is also about opportunity.

Taking the ‘danger’ perspective on risk first, fundamentally it is a way to capture the degrees of uncertainty around the future.

Let’s put this in plain English and in an example for you. Say, for example, you have two financial instruments – a government bond fund and a stock fund. A government bond is a safe instrument – the government can raise taxes, print money and usually pays its bills on time. This, in turn, means that the uncertainty around the future of this investment is low – investors can be confident the instrument will hold its value due to the large resources at the disposal of the government. The result is that the ‘volatility’ of the asset is low as well, which refers to the amount it ‘fluctuates’ – moves up and down – on the market. And usually, you can expect volatility from these types of assets to be around 2 to 5%.

 

Turning to the stock fund. Firstly, a stock represents an ownership in a company, which in turn needs to compete in the open marketplace to sell its products and services. It does not have the resources of the government and cannot print its own money, meaning there are considerably more uncertainties around its income in the future. This higher uncertainty is subsequently expressed through a higher dispersion of returns – as investors are less sure about the future of the company compared to the government, the moves in the price tend to be larger. Stocks usually have volatility levels of between 15 to 20%.

 

There are, in other words, more ‘dangers’ involved in investing in the stock market, but on the other hand, there are also more ‘opportunities’. This is an important point to make because the fact that stocks have higher volatility should not be ‘negative’ per se since you can also make higher returns in the stock market as well. Indeed, over the long-turn, you can expect stocks to earn 6 to 7% more than bonds, but you should also expect that they will experience higher volatility in the process.

Let’s wrap it up! When you see the term ‘volatility’, it refers to the amount of ‘risk’ you would be taking with your investment. This ‘risk’ captures the future uncertainty of the investment and is expressed in the form of a percentage, ranging from low, 0 to 5%, found in cash and safe government bonds, to 15-20%, which is found in the stock market. This risk, however, is not all bad – as risk also comes opportunity. And managing risk and exploiting these opportunities is what successful investing is all about!

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