Broker Check

Behavioral Finance- Volatility and Risk

February 06, 2017

With recent news and media reporting a stream of uncertainty, it's natural for investors to feel emotional about recent market volatility and "risk" to their investments.  It is natural and human to feel concern during volatile political and/or economic times.  It is just as important to respond in according with long-term facts and long-term goals, rather than reacting based on a temporary feeling or emotion.

First, let's define Risk:

Risk is the chance of permanent loss of capital.  Volatility is unpredictability, both high and low, around a long-term trend line.  One has absolutely nothing to do with the other.

Why does anyone get out of the bottom of the market? Because he/she looks at a temporary decline (because they're all temporary declines), and he/she says "I have lost __% of my money".  The emotional investor mistakes volatility for risk, selling and creating the risk he/she feared in the first place.

The intelligent investor knows that, in fact, they have not lost anything unless they sell.  This is a distinction that is assisted by saying: "STOP.  Our goals haven't changed today, therefore our investments shouldn't change today".  The intelligent investor bases this decision on a long-term, multigenerational, day-specific and dollar-specific investment plan - the key to successful investing and retiring.

This is the behavior the emotionally effective investor gets right and the emotionally ineffective investor gets wrong. Our culture, confusing the difference between volatility and risk, hijacks investors' mindful ability to distinguish between temporary declines in its equity portfolio (volatility) and permanent losses (risk).

it is the uncertainty of equities' short-term return—its “volatility” above and below a consistently rising trendline of long-term value—which is the direct cause of the return premium.