Risk, Volatility, and Diversification

What is Risk?  What is Volatility?

Risk is a difficult term to define.  In finance, risk is usually defined as the possibility that an investment’s expected return will be different from it’s actual return.  For most people, risk is thought of as the possibility of permanently losing your money.  Whichever definition you prefer, it is important to note that risk is not the same as volatility.  Volatility refers to the degree of fluctuation and variation of a security’s value over a period of time.  You can think of volatility as the degree of fluctuation of a stock’s price over time.  A volatile security will have higher swings in its price, both up and down.

Different securities have their own risks and volatility.  For example, stocks are considered riskier than bonds.  But not all stocks have the same risk and volatility profile.  The same can be said for bonds.  For example, high yield bonds have a higher credit risk when compared with government bonds.

Diversification and Risk Reduction

Diversification is a technique in which you mix a wide variety of investments in a portfolio.  It is one way you can reduce investment risk.  Ideally, the holdings will have little correlation with each other.  Diversification can be achieved by investing in a different number of securities within an asset class.  For example, instead of owning only one company’s stock you invest in a number of stocks from different companies.  Investing in an index fund, such as the S&P 500, is an easy way to have a diversified holding of equities.  In one fund, you essentially have shares of all 500 companies on the index.  Having a diversified portfolio among different asset classes, such as stocks and bonds, can also help with reducing risk.  It can also help in terms of reducing volatility when compared with an all-equity portfolio.