Risk it for the biscuit: Volatility and risk are not the same

It's the last leg of the Amazing Race and you are barrelling towards the finish line. The only thing separating you and $1 million is Drake's Passage. These are the world's roughest seas between Cape Horn and Antarctica, where waves, winds and currents conspire against adventurers. If your chief aim is to get there first, you can go full throttle and invest in some seasickness tablets. In doing so, you are taking on often confused concepts: volatility (the turbulence of the journey) and risk (the chance of not making it to the finish line due to engine failure or hitting an iceberg).

Investing is no different.

Many investors often use volatility and risk interchangeably, and while they are closely related, they are not by any means the same thing. This is what Warren Buffett wrote about the difference between the two:

"Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments -- far riskier investments -- than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: volatility is far from synonymous with risk."

Buffett is pointing out that investing in stocks has historically been one of the best things you can do to compound your wealth. Just because an investment is more volatile does not necessarily mean it is more risky in the long-term. In fact, staying very "safe" and not investing at all is far riskier, as you are exposed to permanent loss possibilities (even with low volatility) of the currency or asset you use to hold your wealth. Unfortunately, we don't all have Buffett's discipline, but we should try to learn something from the sage.

Volatility cannot be ignored when money is needed in the immediate future (i.e. to purchase a house) as you may be forced to sell and take a loss when the investment has only temporarily declined. But as your investment time horizon gets longer, the effect of volatility is reduced greatly and you should really just be worried about risk (now that you know what it is).