Beginning Investing: Understanding Risk and Volatility
When you start to have a little bit of money to invest many people think that’s when it is time to pick a stock. You have popular companies in mind, and you start to ask what others think about them. Some of you may even go to social media for an opinion, (if this is you, see my article about where to go for investment advice). You might even blindly decide to put your money where your dad told you, or you just chose Apple or Amazon (who could go wrong with those, right???). If you use any of these methods to make your first investment, my guess is you weren’t all that confident about your bet… I mean investment. 😉
We need to distinguish the difference between placing a bet and educating ourselves to invest in something. They are not the same. Let’s start with the education; save betting for Vegas.
Risk versus Return
When you begin looking for the right investment, you should understand the trade-offs or risk of the investment. When investing, we call the dispersion or swing in returns that have historically been experienced risk. In investment-speak, we call this standard deviation. Let’s say our investment has a price of $5, then our investment moves to a price of $10 the next day, and then to a price of $1 the next day. If this type of price change continues, we would call this investment riskier than an investment whose price stays between $4 and $6 as a norm. Here is a graphical view of our example:
Now using that same example, the opportunity for a greater return MAY exist with investment 1. However, just because an investment has a lot of volatility or risk does not necessarily mean a higher return potential exists, you have to find those that do if this is your investment type of choice. The blue investment 1 starts at $5 and then moves to $10 quickly and provides a return of 100%. Investment 1 also drops the next day drastically, making it harder to recoup the initial investment let alone provide some return.
Investment 2 has smaller fluctuations in price providing a less dramatic downward movement and also a less dramatic upward movement. Many find this type of change more comfortable and are willing to wait for a slow and steady return over time.
You may prefer one investment over the other, but you can also own both types to create a total portfolio with an ideal average target risk and return scenario for you. We call this diversification and use asset allocation to create a portfolio. With asset allocation, the goal is to own investments that provide returns in different market cycles so that you can protect your losses and minimize the volatility of the overall portfolio.
Here is an example of historical volatility or risk for different types of investments:
I selected a group of U.S. tech stocks like Apple and Microsoft (represented by Technology Select Sector SPDR investible ETF ticker XLK ), a group of United States Long-term Treasury Bonds (represented by SPDR Portfolio Long-Term Treasury ETF ticker SPTL), a group of small international emerging country stocks (SPDR Portfolio Emerging Markets Small Cap ETF ticker EWX), and cash (represented by SPDR Bloomberg Barclays 1-3 month T-Bills ticker BIL). These are not security recommendations just examples.
You see over the last one month period that some investment types move more wildly than others. Many factors impact each of their movements, but you need to understand the basics, or feel confident your money manager understands those details for your specific investment of choice. How else can you be sure your investment will benefit you? If you can’t feel optimistic about your investments as a whole, then you are just betting. Sure unexpected things happen, and there is no guarantee of a specific return, but the more educated you are, the better you will feel about your future. Right?
Now, I want you to compare what happens to your investment volatility when you invest in a single stock versus a group of securities held in a mutual fund or ETF. (disclaimer: all securities respond differently to the sector, market, or company news on a day to day basis. The above is just an example and not a recommendation to purchase or sell any particular security.)
Remember mutual funds and ETFs invest in a basket of securities, it could be a basket of stocks or bonds or another security type. The S&P 500 SPDR ETF (SPY) and the Vanguard Balanced mutual fund (VBINX), which is a 60% stock and 40% bond basket, offer a smoother ride in the markets because they have a collection of securities within one investment that balances out each stock or bond’s individual risk. Compare those to the AAPL–Apple Inc and AMZN–Amazon stock. When you own just a single stock, you are much more exposed to higher highs and lower lows, and that has the potential to make you a more emotional investor. Emotions can lead to insecurity and panic, potentially causing poor decision making.
So, if given $1,000 to invest, where would you put your money? The answer will depend on what you already own, what are your goal timeframes, how much risk or volatility are you comfortable with, and whether or not you understand your investment idea.
Click here for more information on how to select the right mutual fund. Check back at the end of March under the financial education tab; we will have a new course showing you exactly how to pick your investments.
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