Risk, volatility and correlation: ups & downs explained
Risk vs. Volatility
As we discussed in our myth busting post, there is a huge difference between risk and volatility. Risk measures the likelihood of an investment’s failure. Volatility measures the severity of ups and downs you experience throughout an investment.
What this essentially means for you as an investor is that you should use an investment strategy within your risk tolerance. You should also make sure any volatility you’re likely to experience doesn’t impact you during your investment horizon.
Investment Horizons
As a young investor, you are probably saving for retirement (which could be at age 60, 75, or even 40… totally your call, friends). Whatever your current age, you should be able to know when you can retire. Call this your retirement ETA (estimated time of arrival). If you don’t know this yet, don’t worry, I’ll be writing a full post on how to calculate this later on.
Now, say you are 35 years old today and have a retirement ETA of 40; Meaning in 5 years, you would technically be able to retire. How much risk and volatility would you be able to withstand at 35? Not much.
Stock market boom & bust cycles
Stock market cycles (booms & recessions) happen every 3-5 years on average and typically last 6 months to 2 years (based on history). So, if you are 100% invested in the stock market at 35, by the time you reach 40, a recession may or may not hit us. If it did, this would spell disaster for your poor old investment portfolio.
On the other hand, if you are 28 years old and plan to retire by 40, you would be less vulnerable to a recession at age 33. Why? Well, because a market recovery is likely to happen in less than 2 years, which means by the time you are 35 (5 years away from retirement), your portfolio would be recovered and would even have some time to grow further!
These are all assumptions, of course, but they are based on history. And it helps illustrate why volatility is alright when you are far away from retirement.
How do we measure risk & volatility?
We can measure volatility easily. It is done using a metric called Beta. If you look it up on Investopedia, you’ll see “Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the entire market or a benchmark”.
A Beta value of 1.0 means the stock we are interested in is exactly as volatile as the overall market. No more. No less. A value of 0.5 means the stock is less volatile than the overall market. A value above 1.0 means the stock is more volatile than the overall market.
And how do we define “overall market”? It is usually defined as the S&P 500 index.
Examples of measuring volatility
Let’s say we want to measure the volatility of Apple stock (AAPL). If you open up the Yahoo or Google finance page and search for “AAPL” you’ll usually get a full summary of all kinds of metrics on the stock. For example, you can see price, 52-week high/low, earnings per share, etc.
You can learn more about these later, but for now, want to find the stock’s Beta. When we look at AAPL, we notice the “Beta (3Y Monthly)” as of Dec 7th 20218 is 1.13:
This means AAPL is only slightly more volatile than the overall stock market.
On the other hand, if we look at IBM stock (IBM) on Dec 7th 2018:
We see that it has a “Beta (3Y Monthly)” of 1.87. This means IBM is a lot more volatile than Apple as a stock over the last 3 months.
What is Correlation?
Another important concept that will crop up throughout your investment journey is correlation. Quite simply put, correlation tells us how one stock behaves compared to another, and whether there is even a relationship between the two stocks.
For example, you could expect Starbucks stock is positively correlated to the S&P 500 and inversely or negatively correlated to the price of coffee beans.
Positive correlation with S&P 500: When the S&P 500, a market index that generally reflects the state of the US economy, goes up things are well in the markets. And people are making money. More money made means more money to spend. And since everybody loves coffee (see? we don’t make sweeping generalizations here), people buy more coffee. Which means Starbucks makes more money. S&P 500 up, Starbucks up. Positive correlation. There.
Negative correlation with coffee bean prices: When coffee bean prices go up, Starbucks now has to pay more to acquire coffee beans. Since they don’t change coffee prices often, their costs go up but revenue stays the same. This means their profits go down and their stock becomes less attractive to investors. This, as you guessed it, leads to a drop in their stock price. Coffee up, Starbucks down. Negative correlation.
Negative correlation between stocks & bonds
Generally speaking, stocks are negatively correlated to bonds. As stocks go up, bonds go down. And as stocks go down, bonds go up.
This is not always the case though. There are many factors that can influence stock & bond prices, and sometimes they can temporarily become positively correlated.
Let us look at one of the main factors that impact stocks & bonds: interest rates.
The relationship between interest rates, stocks, and bonds
When interest rates fall to say, 2%, and when the government issues new bonds, these new bonds pay lower rates (around 2%, the current rate). Bonds that governments issued in the past pay more interest than the new ones, say for example, 3%. The old bonds become more valuable to investors; Investors can no longer buy the 3% bonds today, and will be happy to pay premium to acquire the 3% bonds from folks who bought them a year ago.
“Wait, people can buy bonds off each other?” Yes! Believe it or not there is a bond market out there where people and companies trade bonds with each other.
Now at the same time, when interest rates fall, companies are able borrow money from banks at cheaper rates. Cheaper loans mean more cost-effective borrowing. This directly impacts profitability and revenue in a positive way!
Stocks typically go up when interest rates fall. I say “typically” because there is nearly never only one variable affecting stock prices. So oversimplifying things to “interest rates are down therefore stocks are gonna surge” is not cool.
In dramatic times, stocks & bonds are negatively correlated
When stock prices drop dramatically, or when investors think they are about to, bond prices usually go up. Why? Investors consider bonds to be a safe haven. The most common places investors send their money when quitting on stocks are either: bonds, gold, or cash (bitcoin too, but I really don’t wanna start that conversation right now).
So, during high volatility times or when the stock market drops significantly, bond prices tend to go up.
Conclusion
Volatility is okay when you are not planning to retire soon (within 5 years or so). Stock market booms & recessions happen every 5 years on average – with many exceptions, of course. Beta is a metric you can use to measure a stock or ETF’s volatility relative to the overall market. You may assume stocks are negatively correlated to bonds most of the time. During crazy times in the markets, stocks are usually more negatively correlated to bonds than other times.