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Volatility versus risk - Knowing the difference can help make you richer

Like rains, stock markets can be unpredictable, as well. Whether it’s elections one year or a series of tweets by a President the other, markets tend to react.

In Bangalore, rains can be quite an unpredictable affair. The morning can see a shining sun and by 4 PM, dark clouds make a sudden appearance and the following three to four hours see a sudden downpour.

These sudden rains normally meet a mixed reception. For everyone on the roads it’s just more about cursing at the extra hour, or more, they will take to reach their destinations.

Stock markets are volatile

Like rains, stock markets can be unpredictable, as well. Whether it’s elections one year or a series of tweets by a President the other, markets tend to react.

But why? Simply because markets are after all made up of people, directly and indirectly, even in this day and age of algorithms and AI. Markets, and in turn the stock of companies that are traded on the stock market, are subject to such a complex cocktail of factors that even experts generally can’t say what will happen to individual stocks on a particular day. 

The only relative certainty in this uncertain environment is that over long periods of time, the stock prices of companies that do well as a business tend to go up. Figuring out which these companies will be, is not easy.

The opposite is true for the not so great or downright bad businesses. Their stock price in the long run will head down, even if they are “liked” by the market on some days, weeks, months, or even years. 

Stock prices though, being subject to the buying and selling of thousands of entities do look like a crazy ocean wave that doesn’t seem to know which shore it wants to head towards. This doesn’t make stock prices on aggregate “risky”, but volatile. 

The dictionary meaning of volatile is “liable to change rapidly and unpredictably”. Stock markets in the short term, at least, do exactly this. Any complex system is by default unpredictable in the short term because the sum of the parts is different from the whole!

Smart investors avoid the possibility of choosing bad stocks by investing in a portfolio made up of multiple stocks that have a proven track record and in companies that show signs of doing things that will place them in a good position in the future. Good diversified mutual funds try to do exactly this.

Does this make stock markets risky? 

Risk is normally associated with the possibility of a bad outcome. In the stock markets, if you consider “bad outcomes” to be share prices going down, then it’s almost a certainty. Stock prices drop almost daily. They rise as well, with almost the same frequency. The frequency is subject to variation and so is the scale.

Market experts use a diverse array of tools to make sense of all this and take a call. These calls can in turn be good or bad depending on hundreds of factors which themselves change over time.

Risk, in equity investing is truly about whether you chose the wrong stocks in relation to your aims. Shares of companies that don’t do well are punished and eventually discarded by the markets, if they don’t perform for too long. Nobody wants to buy such stocks.

Smart investors avoid the possibility of choosing bad stocks by investing in a portfolio made up of multiple stocks that have a proven track record and in companies that show signs of doing things that will place them in a good position in the future. Good diversified mutual funds try to do exactly this.

What does this mean for you as an investor? 

Equity investing through any form will see volatility, especially in the short term. This is precisely why it is suitable only for long term goals which are years away (more than seven, if you want to attach a number to it). But this volatility is not risk. It’s merely a feature of this particular asset class.

The risk though is about what you invest in, within equity, and whether they will help you reach whatever long-term goal you are planning for. Most good diversified mutual funds deliver a rate of return that is above inflation, at the very least. This tends to meet most long-term objectives.

You should, therefore, not worry too much about the highs and lows of the waves of the markets. Stay on the sturdy boats of good equity mutual funds that will help you get to your destination through these waves.
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