Financial Briefs – Volatility is Not Risk

Financial Briefs are a new section here at retirement is possible. They are short posts, generally only 500-600 words, covering a very specific topic. The idea is that you can quickly see a bit of news, find out how to solve a problem, or get a new insight. Let me know what you’d like to see in future Finance Brief posts. To see more Finance Brief posts check out the Finance Briefs Index.

 

One thing you commonly hear when it comes to the stock market is how risky it is. You hear this a lot when the market is going down. Even sometimes when it’s not. You also hear that it’s like gambling. The market can appear to be risky, but that doesn’t mean that it is. The stock market has gone up and down as long as it has existed. Keep in mind that stock trading has existed since before the United States existed. And in all that time the markets have gone up and down. But just because it goes up and down doesn’t mean that it is risky.

 

The stock market in general isn’t risky It’s volatile. Volatile means that it goes up and down. So in the short term the market will add and lose value. Sometimes a lot, and sometimes in a short period of time. But over the long term the stock market in general works its way up. That’s because the day to day market price is based on short term information. The long term price is based on the foundational health of the long term economy. In the long term the global economy is strong because we produce countless goods and services and rely on those for our continued existence. This means that even when we have a bad year we will still eat. We will still buy things. We will still need transportation. So eventually the market will recognize that and correct.

 

Now, this is about the market as a whole. Individual stocks may be riskier since the strength of an individual company is rarely stronger than the global economy. So how do you maintain the safety inherent in the global economy? Buy lots and lots of stocks in different companies and industries. How do we do that? The simplest way, especially for new investors, is to buy into a mutual fund. I recommend an S&P 500 index fund since it will give you the stability of owning stock in 500 of the strongest companies in the US. It will occasionally go down in value. But in the long term it will go back up. That’s because the market as a whole is volatile not risky.

 

So what is risk? Risk is the chance you’ll lose money permanently. Diversification and research are the two best ways to get around risk. Diversify by buying stocks in several companies. Or better yet buy mutual funds so that you can effectively buy stocks in hundreds of companies. Second, do your research. Buy into companies that are not only making money, but also have a solid plan for maintaining it. A company like Procter and Gamble owns several multibillion dollar brands covering household products that people use every day. That is something very difficult for another company to take from them. It makes good money and has a pretty good plan to make more. A company like P&G continued to make money during the 2008 recession, but the stock price went down. Since the company was still making great money the stock price eventually went back up to reflect that.

 

In short, risk is the chance you’ll lose your money. Volatility is how much the stock price moves up and down. If you buy solid companies then ultimately the value will be maintained and the price will go up. Even though at times the price will go down.