In investing, the biggest assumption we make is that risk is rewarded. If you want your money to grow, the theory goes, you need to put something on the line. Risk is tricky, though. What is risky for one person might not be for another.
Volatility is a good starting point for ordinary investors to think about risk. Volatility refers to how much the price of something moves. If a share price changes often, we say the share is volatile. If it’s largely predictable, it’s not volatile.
A cash savings account with a fixed interest rate at a big financial institution is not volatile. You know how much you pay for the account, how much interest you’ll earn and the probability that the bank would close down. Some of these assumptions are part of your agreement with the bank, some are based on observations of the world around you. If the bank has been around for a long time and no banks recently shut down, you feel at ease leaving your money there. Your risk is very low because you can mostly predict what will happen to your money.
Shares are a different ball game. When there are more buyers than sellers, share prices go up. When there are more sellers than buyers, prices go down. Buyers and sellers make choices based on a range of factors. Hard facts can have as big an impact on a share price as fuzzy feelings. People who buy and sell shares can be influenced by news about companies, politics, the economy and even the weather. They also react to the financial results listed companies are required to publish every year.
Companies can influence their own share price by issuing more shares or buying back shares in the market. World events that have nothing to do with individual companies can have a massive knock-on effect that can influence a share price, like a financial crisis in America.
Because prices are unpredictable, shares are considered volatile assets. Volatility is a risk, because a share price may fall below what you paid for it and not recover by the time you need to sell your share. Sometimes you have no control over that. If a company goes belly-up, the share price won’t ever recover. You will lose money.
However, you do have some control over when you sell. When you have a long time to invest, you can mostly ignore short-term share price movements and wait for your share price to go up before selling. This is where the reward comes in. There is technically no upper limit to how much money you can make. Your stable bank account can only ever give you as much interest as you agreed to, while your volatile share can go higher in value indefinitely.
When thinking about your personal finances, think about how much time you have to invest and the volatility of the savings and investment vehicles available to you. The more time you have to stay invested, the more volatility you can afford.