The World According to Uncle Jim
What Not to Believe about Risk and Volatility
It can be fun to listen to your Uncle Jim talk about the stock market around a few cold ones and a Thanksgiving turkey. Uncle Jim sounds like he knows a thing or two about investing. He tosses around phrases like “this stock has got some serious alpha” and “that stock has been really risky lately”. After all, he’s so loud and so full of cold ones and Thanksgiving turkey, that you can’t help but think that he’s onto something.
How do I know? Well for starters he just confused risk with volatility. It is your first and best sign that Uncle Jim doesn’t know what the heck he’s talking about. But you still love him, and everyone agrees he’s the best guy to call at 3 AM when you’ve run out of gas or gotten dumped. As long as you quietly discount his investing prowess.
Risk and volatility are the two words I’ve found to be the most misunderstood in my career. In fact, many people, like Uncle Jim, think they mean the same thing. It’s absolutely false. So let’s break it down for all the Uncle Jims out there.
Let’s say your buddy wants to open a sports bar. He comes to you and asks you to invest $10,000. You ask yourself, “How risky do I think this is? If I give him $10,000, it could go on to become huge, and he could double my money, or he can come back to me in a year and say, ‘It didn’t work out, we’re going out of business, and all I can give you are some empty kegs.”
This scenario is a measurement of risk. The risk is typically higher for the “your buddy is opening a sports bar” story than say if you invested that $10,000 in a large established stock like Apple™. Apple™ could certainly go out of business and not return any of its dollars to investors, but that is much more unlikely than your buddy screwing up. Risk assessment requires that you envision the outcome, from both a positive and negative point of view.
So what is volatility? Volatility is when an investment fluctuates in value over time. So you might invest $10,000, and it goes up to $15,000, and then it drops to $8,000, and then it goes up to $12,000, and then the investment drops to $7,000. That’s volatility. Let’s look at Apple™ again. There are times when it is wildly volatile, where the stock moves and fluctuates in value a lot. It doesn’t necessarily mean that it is risky, that we are worried about it going out of business, it just means that it’s volatile. Like Uncle Jim when he watches the Steelers.
Many times people see an investment that has high volatility, and immediately assume it’s risky and stay away from it. That’s the wrong mindset. You need to assess the two dynamics separately and here’s the key to making that judgment call: Always seek to avoid or reduce risk. Your appetite for volatility, however, is directly related to your desire for growth and return. If you can’t stomach, the highs and lows, put your money in a savings account, it won’t fluctuate at all. But at the same time, current interest rates on a savings account are about half a percent annually, so you’re not going to get a lot. If you want greater opportunity for growth, on the other hand, you have to accept the potential for volatility. .
So rest assured, the more you know, the less you’ll fear the vicissitudes of the stock market. It will also make your time with Uncle Jim a heck of a lot more enjoyable. Unless the Steelers lose!