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One of the most common mistakes made by people new to investing is confusion between the meaning of volatility and risk. Not fully understanding this difference can lead to unnecessary stress at best, and heavy financial losses at worst.

Artemis Capital Management recently published a paper titled “Volatility and the Alchemy of Risk”, exploring the Global Short Volatility Trade and looking back at Black Monday, the 1987 global stock market crash. You can find out more about what caused Black Monday in the PDF attachment to this post.

Thibaut de Roux is a senior banking executive with close to three decades of experience in financial risk management, who most recently worked as the Head of Global Markets at HSBC in London. Understanding the difference between volatility and risk can make the difference between having a profitable investment portfolio and losing money on your investments.

Volatility Vs. Risk

In the simplest terms, the difference between volatility and risk is the investment time horizon. You can find out what this is in the short video attachment.

Risk can be defined as the overall likelihood that the shares or other investment will eventually be sold for less than the amount the investor initially purchased them for. Volatility, on the other hand, refers to how much and how often the value of those shares or other assets fluctuates within the markets.

Prices for shares may move up and down rapidly in volatile market conditions, but remain more stable in less volatile economic times, where their performance can be more easily predicted. Many investors who watch their portfolio’s performance too closely misinterpret volatility for risk, resulting in poor decision-making.

Successful stock market investment requires a long-term investment outlook. The stock market historically outperforms alternative investments almost all the time, but only when investors are prepared to retain their investments for a minimum period of around ten years.

Identifying Market Risk

The most successful investors are able to identify the level of market risk for a particular company or asset. Warren Buffet once coined the term “economic moat”, to describe how safe a company is in the long-term. Companies with a wide economic moat are more likely to be recession-proof and have safe cashflows, even in times of economic volatility.

For example, a company such as UPS in the United States has a vast economic moat as it would take a huge amount of time and money for another company to actively compete against them. The multi-billion portfolio of assets held by UPS, which include trained personnel, facilities, aeroplanes and trucks, is simply too extensive for even the largest logistics company in the world to compete with in the US market, so this is a low-risk investment.

However, a fashion clothing retailer, no matter how well-established, will always have a small economic moat. This is because it will always be possible for another fashion retailer to compete and take custom from them in an industry that is not capital-intensive.

Benefitting from Market Volatility

An investor with a portfolio that is diversified but contains low-risk investments such as UPS in the example above can actually benefit from high levels of market volatility. Volatility creates opportunity, particularly where less experienced investors are likely to panic and sell shares at a lower price than their actual value due to a rapid downswing in the market.

In periods of high volatility, option premiums are also higher, creating opportunities for savvy investors to sell covered calls and put options to increase their investment income. In the infographic attachment you can learn more about put options and other commonly used stock market terms.