Most people have grown up learning that risk is the likelihood of a negative outcome. For some, it's something that we feel like we need to minimize at a times. However, within the investing world, our understanding of risk is challenged since required returns are not possible without risk. Instead, risk can be explained as outcomes that aren’t planned or expected. The occurrence of such an event will result in an increase or decrease in the value of the asset (stock, bond, ETF, or any investment).
Assets whose prices fluctuate more dramatically are considered riskier since unexpected events have a greater impact on the price. How do we know if we are taking too much or too little risk?
Bring in the statistics
The price of an asset is quantifiable and can be tracked regardless of the currency (dollars, pesos, euros, etc.). By following the price movements, we can see the fluctuations over time and start telling a story with the daily return.
We can visualize the daily return on a chart. Let's take a look at an example of $AAPL.
It's hard to build context by just looking at one asset. Let's compare the price movement of a whole basket of bonds by looking at the daily return of $IEF.
The fluctuation in daily returns we have noticed can be annualized into a new statistic to allow us to better compare the expected risks of different assets. The statistic is called the standard deviation or volatility.
A higher volatility means that the daily returns are more spread out and further from the average daily return; whereas, lower volatility means the daily returns are closer together and more in line with the average daily return. The volatility tells us a lot about an asset's risk—more volatility means more risk!
To put things together and make volatility applicable, let's revisit our examples from above and compare the risk of Apple to the risk of bonds. On any given day, the daily return of APPL typically lies between ±5%; however, the daily return of IEF is usually between ±1%. When we annualize these changes by calculating the standard deviation, we get to a volatility of about 34.0% for APPL and 6.8% for IEF.
This means that $AAPL exhibits 5x more volatility and is therefore considered much riskier than $IEF. All of this math just proves what we may have already been told, that stocks are riskier than bonds.
Looking at how the price of an asset fluctuates over time will help you get a sense of how risky the asset is; however, taking it one step further and finding the standard deviation allows you to compare the level of risk between asset classes and the risk of assets in the same class.
This can also help you decide how much risk you are comfortable with and which investments are appropriate for a portfolio. For example, a standard deviation of 15% might be too much for some but not others.