The importance of learning the difference between volatility and risk

By Bob  || October 13, 2025

Risk, reward and probabilities

There is a basic concept in investing which is good to review.  If you accept a higher level of risk, you should be compensated with a higher rate of return. For fun, let’s look at the Washington State Lottery to see how probabilities, risk and reward are connected. As we have said before, buying a lottery ticket is NOT investing. It’s speculating. If you want to spend a few dollars on a lottery ticket, consider it purely entertainment just like you might consider buying a ticket on a roller coaster ride. Onward…

The game is predetermined to have winners and losers 

You can currently spend $2 to buy one Washington State Powerball ticket. The potential payoffs decrease as the probability of winning increases. But it’s still a bad deal! Let’s take a look:

-The payout for the Jackpot is set at 1 in 292 million (much more remote than being struck by a meteorite at 1 in 74 million.)

-The payout to win $1 million dollars is set at 1 in 11.7 million (slightly less likely than being killed in a plane crash which is approximately 1 in 11 million.)

-The payout to win $50,000 is set at about 1 in 1 million (about as likely as getting hit by lightning during your lifetime.)

– The payout to win $4 on your $2 lottery ticket is 1 in 38.3 (pretty much the odds of having a number come up on a roulette wheel.)

The state lottery is guaranteed to pay out less than the ticket sales. Only 61.74% of ticket sales were paid to “winners” leaving 38.26% to fund government programs, administration/marketing/operating costs of the lottery. The game is predetermined to have winners and losers.

Probabilities and consequences

Risk is the possibility that that outcome will be different from what you expect. There are two distinct components of risk; the probability of an event occurring (how likely) and the consequence of the event (good or bad.) The lottery design, taking account of both probabilities and consequences, is to assure that state supported programs “win” and players “lose.”

You don’t need to be a loser… just don’t play the game.

Expected future returns revisited

In the blog post, Time: The same investment can be either risky or prudent, we tried to connect the dots between how the different assets can be risky or prudent depending on the purpose of an investment and the time horizon.

If the time horizon of your investment goal is short, cash is less risky than equities. Why? Because in exchange for certainty that your cash will be there tomorrow, your expected return is low. You very likely would be happy to forgo a higher return for the certainty of making sure that you have the amount to pay rent on the 1st of the month. Likewise, to achieve your long-term goal of supporting your older self, you need to invest in assets that have higher long term expected returns i.e. diversified, low-cost equity funds.

Let’s introduce Joe and Sally to help explain two important investing concepts: volatility and risk. We will also expand a bit more on the concept of future expected returns.

The Sailing Race Analogy: Volatility, Risk, and Expected Return

Two skippers, Joe and Sally, leave San Francisco for Tokyo Harbor.

First place: $1,000,000

Second place: $500,000

The Boats

Joe’s boat: 30 feet, 13 knots (fast, agile, but easily tossed by rough seas).

Sally’s boat: 70 feet, 9 knots (slower, heavier, more stable in bad weather).

Knots

Knots is a metaphor for future expected returns

Part 1: Volatility (The Bumpy Ride)  

A hurricane rattles both boats.

Joe gets hammered by waves. His boat lurches; he feels seasick and scared-that’s volatility: big, uncomfortable swings that don’t sink you but shake your resolve.

Sally rides the swells more smoothly (lower volatility) but she can’t go any faster than 9 knots.

Key point: After the storm passes, volatility is over. The ocean calms. From here, performance depends on what each skipper does next.

If Joe remains fearful and keeps sailing slowly after the hurricane, he throws away his speed advantage. He will not win the race.

Volatility tests your nerve; it does not decide the outcome… your reaction does.

Assets that have a higher expected return come with higher volatility (getting tossed around.) A diversified equity ETF may have short term price declines of 30-50% vs. cash that has no volatility. Joe may have felt seasick, but his boat is faster and thus he will win the 1st place prize if he picks up speed after the storm.

Part 2 — Risk (The Chance of Permanent Loss)

Decision Point for Joe

Now add risk: the chance of sinking (a permanent loss-no prize).

Joe’s small boat has a higher probability of sinking in a severe storm.

Sally’s large boat has a lower probability of sinking.

Because Joe faces higher risk, he must be compensated with a higher expected return (his boat can go 13 knots). Sally accepts a lower expected return (9 knots) because her risk is lower and her ride is steadier.

What this means to you  

Volatility that applies to highly diversified equities equates to the emotional turbulence of markets (wide price swings, scary headlines). It feels awful but is not a permanent loss.

Risk is the probability of permanent capital loss (either having to sell to raise liquidity or your fear leading to sell). Higher risk requires a higher expected return to be worth it.

Discipline after storms requires fighting against your fear and increase investments in higher expected return assets when you are still feeling seasick.

Key Takeaway: Joe and Sally showed us that having a higher expected return (Joe’s 13 knots) should result in a win if he does not let his inner fear of volatility cause him to slow his boat down. Endure volatility during the storm; recommit to the plan after the storm. That’s how you capture the higher expected return that compensates for higher risk.

Now let’s look at Liquidity: time to convert to cash and friction costs.

Liquidity: Time to convert to cash and friction costs  

Time to convert to cash   

In publicly traded securities you can sell a share of a diversified equity ETF like VTI and receive cash a day later. A publicly traded security that can be converted to cash in one day has one key trait of being “liquid”. Conversely, other investable assets such as private equity, private credit and venture capital have very restrictive terms where an investor may not expect to see a return of capital for 7-10 years which represents “illiquid” investments.

An investor who considers investing in private investments must be compensated for the lack of liquidity compared with public securities that can be converted to cash within 24 hours.

Note: the US government is currently pursuing change in rules to allow private investments to be offered inside of retirement programs. I feel that this is a bad idea as the lack of mark-to-market accounting, poor liquidity, high costs, and opaqueness of underlying investments would result in poor outcomes for many individuals who are unable to assess the myriad of risks.

This topic is worthy of a separate blog post but you might want to check out the link which describes “volatility washing.”  If it were me, I would avoid private, illiquid investments.

Bid-Ask spread = friction costs     

The second measure of liquidity; the difference between what a willing buyer is willing to pay, and a willing seller is willing to receive for the same security is also referred to the “bid-ask spread”. The buyer puts a price out that he/she is willing to buy, called a “bid.” The seller puts a price out that he/she is willing to sell referred to as an “ask.”

In the case of Vanguard Total Stock Market Index (VTI) the bid-ask spread as of Oct 3, 2025 was $.67. The last seller before the market closed on Oct 3 was willing to sell his/her shares for $330.03 and the willing buyer was willing to pay $329.36. Another way to frame this is if you bought a share of VTI and then immediately sold it again you might expect to lose approximately $.67 or .2%.

To illustrate the difference in how wide the bid-ask spread could be let’s look at Rocket Pharmaceuticals, Inc. Warrant (RCKTW) as of Oct 3, 2025, which Bid $0.0295/ Ask $0.0440 or a 33% bid-ask spread. If you bought a warrant and immediately sold it, you might be expected to lose approximately 33% of your purchase price.

Both VTI and RCKTW can be bought and sold in one day but the friction cost between a willing buyer and willing seller is massive.

In summary, how quickly you can turn an asset into cash and what is the bid-ask spread represent two important factors when determine the liquidity of an investment. The less liquid an investment the higher expected return you should seek and expect.

Governance     

Investing in a country that is ruled by a dictator who can change the rules at any time increases the risk to an investor and thus the necessary rate of return to induce the investor. There are many examples where the government of a country has used powers to nationalize businesses. If you happened to own a business that was nationalized, you would lose 100% of your investment. Here are but a few examples:

Russia “Temporary administration” of western subsidiaries (e.g., Danone Russia, Carlsberg’s Baltika). Presidential decrees transferred control to the state; the parent companies described it as confiscation and wrote off 100% of those local assets.

Turkey (Erdoğan) Bank Asya. Regulators seized all shares. The bank was later liquidated, leaving equity holders with no recoverable value.

Venezuela (Chávez/Maduro) The state took over foreign-owned oil projects; parent companies sought international arbitration. These actions eliminated the private equity stakes in Venezuela at the time.

Short of the country nationalizing businesses as described above. Investors can be permanently harmed by other types of state intervention. China is well known to have stolen intellectual property from foreign firms to then provide this knowledge to domestic businesses.

There are companies like Meta (Facebook) that have supervoting rights for certain shareholders.  Mark Zuckerberg owns approximately 13-14% of the shares but he controls about 61% of the voting rights.  Good for Mark but bad for minority shareholders who are unable to exert a management change in the future.

Summary 

Assessing the probability of an outcome is important. The Washington State Lottery example helped connect the dots between probability and reward. Buying a lottery ticket is not an investment and our example clearly showed the state wins and the buyer of the lottery ticket loses. It’s designed that way.

Volatility represents the severity of the storm. Assets with higher expected returns over a long period of time like equities are likely to experience bigger swings in prices. While this may be unsettling, your behavior when facing volatility speaks more to risk. Beware of marketing pitches of private equity that in essence hide high expenses and volatility from the untrained eye.

If you have appropriately planned to invest in diversified, high expected return assets for 20-40 years and understand that these investments are to be left alone you will very likely ride out the storm and realize higher returns.

Conversely, if you needed this liquidity in a much shorter period and/or panicked and sold during the worst part of the storm, you would experience a permanent loss.

Liquidity both in time it takes to convert the investment to cash and the friction cost of the “bid-ask” spread are real costs that need to be compensated. You should be paid a premium if you agree to accept these risks.

Consider walking away if your investment is illiquid for many years and/or you have no ability to determine how much you might lose in the ‘bid-ask” spread. There are many other ways to grow your wealth that are low cost, diversified and liquid.