Fudge and caramel; are they really that different?

One of my favourite bands, still to this day, are the Beastie Boys.

One of their tracks I heard recently was the 1998 release “Just A Test”.

Famed for their sometimes bizarre lyrics, in this particular track they sing"

“…it’s like fudge and caramel, they’re not the same…”.

Regardless of one’s thoughts on the musical and lyrical abilities of the Beastie Boys, they are apparently spot on, fudge and caramel are not actually the same. They are, however, easily confused – and I base this on decades of enjoying both from time to time, never quite knowing the difference myself.

Although not having a sensitive enough palate to differentiate between these two sugary treats, I am fortunately able to distinguish between other, rather more important things that are sometimes commonly-confused.

In particular (since this is a financial blog after all), in almost 20 years working in the financial services industry, I am all too conscious that, in experienced and non-experienced investors alike, two of the most commonly mixed-up and interchanged concepts are those relating to ‘volatility’ and ‘risk’.

Although easily done, it is fundamentally wrong to confuse the two, since an investment is not necessarily riskier simply by virtue of it being more volatile.

Like fudge and caramel, they are definitely not the same.

Defining each:

• Risk is the probability that investment into an asset, or basket of assets, will cause an investor to suffer permanent loss of 'value'.
• Volatility is a measure of the extent to which the 'price' of an asset tends to fluctuate over a period of time.

This distinction is important because there is not necessarily a correlation between the volatility of an investment and how robust that investment’s value is.

In other words, price is what you pay for an investment, whereas value is what you get (hence the emphasis in the above).

Whilst there is a relationship between price and value, it is incorrect to treat them as being identical. An investment might fluctuate wildly in price even though its inherent value remains reasonably steady over the long term.In such an instance, especially where the short-term is concerned, what is changing is simply the market perception of the value of a particular investment.

One of the key differences between volatility and risk as metrics is that only volatility is quantifiable, whereas risk is subjective.

The volatility of an investment is generally expressed as a measure of standard deviation, which is the extent to which its price varies from its average, both on the upside and the downside.

For example, a standard deviation of 5% would indicate that an investment has historically traded within a range of 5% lower and 5% higher than its average price, and therefore the higher the number, the more volatile the investment.

Risk, on the other hand, is immeasurable, since this is largely driven by the investor themselves and their own set of unique circumstances, such as their tolerance and capacity for loss, and most importantly their investment horizon.

An investor with a very long timeframe over which they are able to invest faces a lower level of risk than the investor who will require access to the capital within the next several years or so.

Knowing this, and being accepting of this, although different things, not uncommon for even a long-term investor to panic when faced with volatility, leading them to sell an investment at a loss, either to avoid an even larger loss or because they need the capital. In such an instance, it is not volatility that has caused the investor to suffer a loss, it is their intolerance for risk.

Volatility is therefore something that we must manage effectively, especially if there is a known (or unknown, but suspected) need for capital in the short-term.Indeed, it is for this very reason that clients are generally advised to keep a reserve of cash available to meet income and capital needs for around the next three to five years.

Taking this approach means that we can be less concerned about short-term fluctuations (i.e. volatility) and focus on selecting those investments with intrinsic value that have the potential to deliver the required return over the long term, with minimised risk.

As long as investors understand, appreciate and become accepting of this, then they, like me, can worry about the not so important things in life, such as whether fudge and caramel really are the same or not….