Investors recognize the inverse relationship between risk and reward: the greater the potential reward, the greater the inherent risk. The reward component generally is well understood. Specifically, investors experience reward when an asset serves the intended function of preserving value or generating income and/or capital appreciation.
Risk, though, is more nuanced. Frequently, investors associate risk with volatility. We counsel clients to differentiate between the two concepts. Volatility simply represents the change in the value of an asset. On a day-to-day or month-to-month basis, nearly all asset prices fluctuate. Some asset values change more than others (stocks v. bonds, for example) and some periods present more volatility than others (epitomized by the sharp ascent and steep decline of the “dot com” era). Volatility usually proves to be a temporary phenomenon.
We view risk, on the other hand, as the potential for a permanent loss of capital. Unlike the temporary decline in value resulting from periodic volatility, the permanent impairment of capital can structurally disrupt progress toward investment goals. As long as one doesn’t need to sell when prices are low, then volatility can be endured—thus the rationale for establishing liquidity needs at the inception of the relationship. Volatility actually is the friend of long-term investors who seek to acquire assets when prices are low, then dispose of them when prices are high.