The Effect of Volatility on Investment Risk and Return

Investing in stocks and bonds is not
like putting money in a bank account where one can calculate the
interest rate and know the value at a future point in time.  Stocks
and other assets go up and down in price and one cannot predict what
price they will be at one year, one month, or even a few days in the
future.  The level of these fluctuations varies with the asset type
and the specific investment.

The size and frequency of these
seemingly random motions is called volatility
and is often described by a quantity called an investment’s beta.
Basically a beta of 1.0 means that the asset  has an equal
volatility to the average asset in the market.  Higher values of beta
indicate that it will move around a lot more.   Studies have
shown that stocks with higher betas will do well over long periods of

The stocks of young companies and
companies in industries like semiconductors and biotechs tend to have
high betas.  As can be expected, the price of these assets varies
wildly from month-to-month.  Stocks and other similar assets carry
risk because of this volatility.  It is specifically because of this
risk, however, that  one can make returns that are much better than
bank rates.

The potential return on
an investment is proportional to the volatility.  The relative
volatilities and returns of various investment choices are shown in
Figure 1.

Figure 1

Bank accounts and CDs are
not volatile – the rate of interest is easily calculated such that
the value at any given time will be known.  There is a slight risk
that the bank may close and not be able to repay the money — a risk
that was reduced after FDIC insurance was started — but most of the
time the money is repaid and one is able to ask for the money back at
any time, albeit with a forfeiture of interest some times.

With stocks and bonds,
the value of the investment fluctuates with time.  One can not be
certain what the value will be tomorrow or the next day, or even next
year – it is whatever someone is willing to pay for the stock or
bond at the time.  Because bonds mature, meaning that the company
that issues them will payback the original loan at some date, they
tend to be less risky.  If the company issuing them, however, is
shaky and likely to default, as is the case with junk bonds, the
stock of a stable company would be less risky because one only risks
loss of a portion of one’s investment if the stock declines in price
rather than a loss of the whole investment which occurs when a
company default on a bond.

For a stock one can
assume that the price will be close to where it was the day before,
but news — good or bad — can cause the price to move by 10% or
more in a day.  Sometimes a stock will rise or fall for reasons that
have nothing to do with the company.  The whole market will move due
to word of recession, war, pending legislation, or other events.
Sometime it is just movements of the stock prices themselves or
various trading strategies that are being employed that will cause a
stock price to move precipitously.

It is this volatility,
however, that makes stocks grow more over time and provide a greater
return than safer, fixed income investments.  Because there is risk
involved, one is able to buy stocks at significant discounts to what
the earnings prospects of the company indicate the price will be.
Because the company may not make the earnings, and later pay the
dividends, that are expected the price will drop until it is low
enough to justify the risk taken.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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