Volatility isn't risk. Confusing the two is.

When markets fall, the instinctive reaction is often simple: "This is risky. I need to get out."

But a falling share price and a risky investment aren't necessarily the same thing.

Volatility describes how much and how quickly an investment's value moves. Risk is broader. It includes the possibility that you permanently lose capital, don't achieve your financial goals, take on more risk than you can tolerate, or need to sell at the wrong time.

For Australian investors, understanding that distinction matters. Investment decisions should be based on your objectives, financial circumstances, investment timeframe and risk tolerance — not simply what the market happens to be doing this week.

ASIC's Moneysmart guidance similarly recommends choosing investments that fit your financial goals, timeframe and risk tolerance, while using diversification to manage portfolio risk.

A falling market isn't automatically a bad investment

Shares and other growth assets can experience significant short-term movements.

That is part of investing.

For example, an investment portfolio heavily weighted towards Australian and international shares may fall substantially during a market downturn. That can be uncomfortable to watch, but the fall itself doesn't tell you whether the underlying investment remains appropriate for your long-term strategy.

The more important question is:

Has the reason you invested changed?

If your investment strategy was designed around a 10-, 15- or 20-year timeframe, a short-term market decline may not change the fundamental objective.

This is one reason Moneysmart recommends investors avoid making decisions based purely on short-term market movements and instead consider whether an investment still fits their goals and risk tolerance.

Selling after a fall can turn a temporary decline into a permanent loss.

That doesn't mean you should simply ignore falling markets. It means you should understand why your investment has fallen and whether the underlying risk is still appropriate for you.

So, what actually is investment risk?

There isn't just one type of investment risk.

Depending on what you own, you may face:

• Market risk — the value of an investment can fall because markets decline.
• Concentration risk — too much of your portfolio is exposed to one company, sector, asset class or country.
• Liquidity risk — you may not be able to sell an investment quickly at a price you consider reasonable.
• Interest rate risk — changes in interest rates can affect investments such as bonds and property.
• Currency risk — overseas investments can be affected by movements in exchange rates.
• Credit risk — a borrower or issuer may fail to meet its obligations.
• Inflation risk — your investments may grow, but not enough to maintain your purchasing power over time.
• Behavioural risk — you make an emotional decision, such as selling during a market fall or chasing an investment after a sharp rise.

Diversification can reduce the impact of some of these risks. Spreading investments across asset classes, companies, sectors and countries means your financial future isn't dependent on a single investment performing well.

But diversification doesn't eliminate risk. A diversified portfolio can still fall when markets broadly decline.

The biggest mistake: changing the strategy because of the headlines

Market volatility creates noise.

One day, shares are falling because of interest rates. The next, it's inflation, geopolitical uncertainty, economic growth or corporate earnings.

Then the market rebounds — and investors who sold may find themselves wondering when to get back in.

This can create a damaging cycle:

• Market falls → fear → sell → market recovers → regret → buy back at a higher price.

The problem isn't that investors are emotional. That's human.

The problem is allowing a short-term emotional reaction to override a long-term investment strategy.

A well-constructed investment strategy should already account for the possibility of market downturns. Your asset allocation — the mix of growth and defensive investments you hold — should reflect both your timeframe and your capacity and willingness to accept losses.

If you cannot tolerate a significant fall in your portfolio, that is important information when determining your investment strategy.

Risk tolerance isn't the same as risk capacity

This distinction is particularly important.

Risk tolerance is how comfortable you are with investment losses.

Risk capacity is how much financial loss you can actually afford to withstand.

You might feel comfortable with a highly aggressive portfolio, but if you need the money within two years to purchase a home, your financial capacity to withstand a major fall may be limited.

Conversely, a long-term investor with stable income, sufficient cash reserves and no immediate need to access their investment capital may have greater capacity to ride through market volatility.

This is why there isn't a universally "best" investment portfolio.

The appropriate strategy depends on the investor.

Diversification: boring can be powerful

Diversification isn't designed to make your portfolio exciting.

It's designed to stop one investment decision from determining your entire financial outcome.

You can diversify across:

• Australian and international investments
• shares and fixed interest
• property and infrastructure
• different industries and companies
• growth and defensive assets
• different geographic markets

Exchange traded funds (ETFs) and managed funds can also provide diversification by giving investors exposure to a basket of underlying assets. However, they still carry investment risks and should be assessed based on what the particular fund actually invests in.

Diversification also needs to be genuine.

Owning five different investments doesn't necessarily mean you're diversified if they all hold similar companies, sectors or assets.

Don't confuse tax benefits with investment quality

Australian investors also need to consider tax.

Investment returns can come from income, such as dividends, distributions or rent, as well as capital growth.

Depending on the investment and your circumstances, tax may apply to investment income and capital gains. Keeping accurate records of purchase costs, sale proceeds, income and expenses is important when preparing your tax return.

Tax considerations can form part of an investment strategy, but a tax benefit shouldn't be the reason you make an otherwise unsuitable investment.

For example, borrowing to invest may provide potential tax deductions in some circumstances, but it also magnifies investment risk. If the investment falls while interest costs continue, your losses can increase. Moneysmart classifies borrowing to invest as a high-risk strategy.

The investment should make sense before the tax treatment is considered.

What Australian investors should check before making a decision

If you're feeling nervous about your portfolio because markets are moving, pause before making a major change.

Ask yourself:

1. What is this money for?

   Is it for retirement, a home deposit, generating income or building long-term wealth?

2. When will I need it?

   Your investment timeframe is one of the key factors in determining an appropriate level of risk.

3. What risks am I actually taking?

   Don't look only at the recent return. Understand what you're invested in and what could cause its value to fall.

4. Am I diversified?

   Consider whether too much of your wealth depends on one company, sector, asset class or market.

5. Has my situation changed?

   A change in income, retirement plans, debt, family circumstances or financial goals may justify reviewing your strategy.

6. Am I reacting to information — or emotion?

   There's a difference between reviewing an investment because its fundamentals or your circumstances have changed and selling simply because the market is frightening.

And if you're receiving financial advice?

Australian financial advice is subject to a regulatory framework designed to protect consumers.

ASIC regulates financial services and financial advisers, and advisers providing personal advice on relevant financial products must meet professional and regulatory requirements under Australia's financial services laws.

Investors should understand what type of advice they're receiving, what it will cost and why a recommended investment is considered appropriate for their circumstances.

Investment products can also come with disclosure documents such as a Product Disclosure Statement (PDS), which provides important information about the product, including its features, fees, risks and how it operates.

Good advice isn't about predicting the next market move.

It's about helping you build a strategy that makes sense before the next market move happens.

The goal isn't to eliminate volatility

Volatility is an unavoidable part of investing, particularly when you invest in growth assets.

The objective isn't necessarily to construct a portfolio that never falls.

It's to construct one where the level and type of risk are appropriate for you.

That means understanding your goals, timeframe, financial position and tolerance for loss; diversifying appropriately; reviewing your investments when circumstances change; and resisting the temptation to make major decisions based solely on market noise.

Because the real investment risk isn't always seeing your portfolio fall.

Sometimes, it's letting fear convince you to abandon a strategy that was designed for the long term.