How not to get caught out in a market rout: Don’t confuse volatility with risk

• Volatility and risk are not the same thing – and confusing the two can lead to some misguided portfolio decisions. Volatility refers to the temporary price swings, while risk pertains to the potential for permanent loss of money.

• Keeping a long-haul attitude can help smooth out volatility, but avoiding volatile investments entirely could have you missing out on substantial returns.

• There are some practical tips you can follow to navigate the market’s ups and downs: avoid constantly checking your portfolio, invest for the long term, embrace dollar-cost averaging, and thoroughly research investments to mitigate actual risk.

Tokyo’s Nikkei index plunged 12%, Seoul’s Kospi fell 9%, and New York’s Nasdaq slid 6% right after the opening bell on Monday. Cryptocurrencies also took a hit. But the VIX (which measures stock market volatility) shot higher, along with US Treasuries, that global bastion of safety. In short, the day was mayhem.

But as investing lessons go, it was sublime. See, figuring out how to handle price swings is just as important as picking the right assets. Honestly, most investors struggle even to comprehend their own appetite for risk: they binge on it during good times and become suddenly averse after a loss.

And the thing is: when you get caught up in day-to-day market movements, it’s easy to confuse risk with volatility – and that can throw you off track in reaching your financial goals.

Here’s what you need to know to handle the market’s wild swings.

First things first: what is volatility?

Volatility refers to how much an investment’s price swings over a given period. High volatility means big price changes in a short time, while low volatility means more stable movements. Factors like market sentiment, news events, and economic data can all drive volatility, but it doesn’t necessarily mean an investment is risky.

And it’s not always bad news. In theory, you could have a highly volatile investment that’s only gone up. And if you’re not planning to sell, volatility isn’t a big deal. It can even be your friend, giving you the chance to buy more shares of a good investment at a lower price.

Okay then, what’s risk?

Risk, on the other hand, is about the potential that you might lose money and never regain it. This is the kind of thing investors truly fear. Unlike volatility, which is usually temporary, risk can mean a forever loss. For instance, if a company goes bankrupt, the value of its stock could drop to zero, leaving investors with a permanent loss. Unlike volatility, risk isn’t something you can see from day to day: it requires a deeper dive to fully understand.

Many financial theories and models, particularly those taught by university professors, equate risk with volatility. And that’s largely because volatility is quantifiable and fits neatly into mathematical models. But volatility is just one aspect of risk and often a poor indicator of the real dangers that investors face.

The difference between risk and volatility. Source: Money Visuals.

Why does the difference between risk and volatility even matter?

It’s easy to see why people mix up risk and volatility. If you have a short investment timeline and are in something volatile, what might be just a bump in the road for someone else could be risky for you. That’s because you might have to sell when prices are low, locking in a loss.

On the flip side, some of the most volatile investments – like stocks – might not be risky for you if they align with your long-term goals. Avoiding volatile investments altogether can be a mistake if your so-called safe investments bring in only small returns. In other words, by focusing too much on short-term ups and downs, you could miss out on the bigger picture.

Understanding the differences between risk and volatility has some real advantages:

For one, it can help you make better long-term decisions. Volatile stocks might offer high returns in the short term, but come with significant price swings. Mistaking volatility for risk might cause you to avoid potentially rewarding investments. Conversely, identifying genuine risks can help you avoid investments that could lead you to permanently lose some money.

Secondly, it can help you become better able to stay calm during market fluctuations. For example, during the 2008 financial crisis, the market experienced extreme volatility. Investors who realized that this volatility didn’t equate to permanent risk for all stocks were better able to hold onto quality investments and benefit from their recovery.

Lastly, it can give you a more opportunistic mindset, and help you identify opportunities during market dips. Volatile markets can present buying opportunities. If you understand that a price drop is due to volatility and not an inherent risk, you might seize the chance to buy valuable assets at a lower price, benefiting when the market eventually rises.

And, last but not least, how can you weather a market rout?

Easy peasy: do these six things.

Stop checking your portfolio constantly. When the market is selling off, the red on your screen can cause you to panic. You should never, ever be forced – whether by circumstance or by emotion – to sell. If you do sell, it should be by choice, and not out of necessity or fear.

Stay informed but detached. You don’t have to check your portfolio constantly, but you ought to keep on top with market news to ensure you’re aware of what’s happening. It’s important to discern between the meaningless noise, and proper, data-driven risk. Remember that day-to-day price changes don’t necessarily reflect an investment’s long-term value.

Invest for the long haul. Holding an asset for longer tends to smooth out its volatility. For instance, the S&P 500 has seen strong growth over decades despite some short-term volatility. All too often, investors that have sold out during a crisis have locked in losses and possibly missed the rebound.

S&P 500 cumulative returns for one-, five-, and ten-year periods immediately following the end of a bear market. Daily data from January 3, 1928, through December 31, 2023. Sources: MFS, FactSet.

Embrace dollar-cost averaging. With a long enough time horizon, you can actually turn a market rout to your advantage. Dollar-cost averaging – investing regular amounts of money at regular intervals, for example, in an employer-sponsored plan – allows you to snap up stocks and bonds in all sorts of market conditions, no matter how you feel.

Know why and what you’re invested in. Ideally, your portfolio shouldn’t be based on the latest fad. Before investing in a company, you should research its financial health, industry position, and management chops. This will help you assess the actual risk involved.

Have a watchlist. Volatility isn’t all bad. Quite the opposite, actually: it’s a chance to snag great assets at a discount. With the right mindset and a solid list of stocks to buy, a market rout isn’t something to fear, but something to cheer about.