Market risk vs. volatility: 3 key differences

Market risk and volatility are two important concepts for investors in financial markets. Regardless of whether investors trade in stocks, bonds, commodities, options or futures contracts, all markets for financial securities are subject to both volatility and market risk.

Individual investors usually hear about volatility and market risk only when markets are going up one day and down the next. But market risk and volatility are two different phenomena with important differences. Knowing these key distinctions can help you protect your portfolio.

What is market risk?

Market risk is defined as the likelihood of losing money invested in financial markets because the entire market is losing money. This is also known as systemic risk. When the markets as a whole are losing money, it is impossible to protect yourself from losses through diversification, but a well-diversified portfolio can help mitigate the risk if risk is relegated to a sector.

Market risk is greatest when something outside the market makes investors lose confidence as a group. Recent historical examples include the onset of the COVID-19 pandemic in 2020 and the war in Ukraine in 2022. These events made market participants fundamentally rethink whether they wanted to be invested in markets at all.

Some market risk is identifiable, but people ignore the signs. For years in the early 2000s, economists like Nouriel Roubini (nicknamed “Doctor Doom”) said that sub-prime borrowing was out of control and would result in a financial crisis. Other instances that can cause markets to slide, like the COVID-19 pandemic, are unpredictable and are known as “black swan” events.

What is volatility?

Volatility is a measurement of how far a security’s price moves in either direction from its mean. You can visualize volatility as a wave moving up and down the piling of a pier. There is a line on the piling below which the wood is almost always underwater, and above that line, the wood is wet only when waves roll in. The line is the mean water level, and volatility is the difference between that line and the highest and lowest places the water touches as waves move past. The bigger the waves, the greater the volatility.

The Chicago Board Options Exchange (CBOE) measures stock volatility by tracking options on the S&P 500 index. The official name for this measurement is the CBOE Volatility Index (VIX), but it is nicknamed the “fear index” because when the VIX reading is high, stock markets are usually in turmoil. Volatility is present to some degree in the price movements of all securities – however, some securities and asset classes are inherently more volatile than others. For example, the price of penny stocks and high-yield corporate bonds are more volatile than shares of well-established blue-chip companies and utilities.

Traders sometimes use the Greek letter beta (β) as a measure of volatility. Beta measures the overall volatility of a security’s returns against a benchmark like the S&P 500.

3 key differences between market risk and volatility

Market risk and volatility both make investors and traders nervous, excited or both – but there are a few key differences worth exploring.

Market risk is a measure of value, but volatility is a measure of price

In investing, market risk is the possibility that you will lose your investment and your capital and not get it back; typically, there is a positive correlation between risk and return. Market risk can be minimized, is forward-looking and is subjective, as different investors may understand market risk differently, and it is not measured against any indexes. When we say market risk measures value, it means it holistically measures all risk factors that can affect an investment portfolio, including significant events that take place outside of the market (e.g., the onset of the COVID-19 pandemic in 2020, the outbreak of war in Ukraine in 2022, etc.).

Market volatility, however, cannot be minimized, is historically calculated on past market performance and is objective – market volatility is measured according to the VIX. Market volatility expressly refers to how quickly market prices change over the short term, meaning it’s not as influential over long-term investing decisions.

Market risk is hard to measure, but volatility is easily (and often) measured

As mentioned above, market risk often comes in unexpected (or under-expected) ways. An autocrat launches a foreign war of aggression, a technological revolution takes industry by surprise or central banks take extreme measures in the face of a financial crisis or inflation shock – each of these scenarios can cause markets to tumble and possibly not recover for years, if they recover at all.

Volatility is a historical measure created statistically from prices. Although the past is not a perfect predictor of the future, it can be a directional guide for investors.

Market risk is difficult to hedge against, but you can hedge against volatility

It’s impossible to completely avoid market risk – all investors take on some amount of risk when choosing to invest in the market. More importantly, it’s difficult to hedge against market risk given all the internal and external factors that influence it.

Market volatility can be part of a hedging strategy, though. For example, more volatile investments typically offer more growth, while less volatile investments tend to provide capital protection in some capacity.

That said, you can protect yourself from market risk to some degree if you have a long enough time horizon and you’re taking thoughtful action. Whether it’s through self-education or by talking frequently with a financial advisor, considering a portfolio adjustment in response to developing market conditions and recent events is not an unwise move.

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