5 Things You Need to Know About Volatility

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23 Jul 5 Things You Need to Know About Volatility

1. What is Volatility? 

Volatility is a measure of variation. If the price of asset A moves more than asset B, asset A is considered more volatile. It is as simple as that.

2. How is volatility measured?

Beta is the most common measure of volatility. It is calculated using regression analysis, and it refers to a stock’s movement in response to the general market. A stock with a beta of 1 is expected to move in line with the market. A stock with a beta of 2 will be expected to move twice as much as the market and when the market rises by 10%, its price should increase by 20%. Conversely, stocks with a beta of less than 1 are deemed to move less than the overall market and hence considered to be less volatile. Finally, stocks with a negative beta will move inversely with the market – the price falls when the overall market rises and vice versa.

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Beta figures can be obtained from financial websites such as yahoo finance. Do note that different data providers use different methods and time frames to derive their figure and it may vary accordingly.

3. What about the volatility of a portfolio?

The volatility of a portfolio is the weighted average of the individual assets in the portfolio. If a portfolio is made up entirely of risky assets that move in tandem with each other, it is only logical that the portfolio fluctuates greatly. However, if the volatility is made up of assets that have a negative correlation with each other, (ie. one is expected increase in value when others fall) then volatility evens out. The most classic example of this would be the composition of the Permanent Portfolio.

Permanent Portfolio Jun 13

Notice how, despite Gold, Bonds and Stocks being volatile asset classes in themselves, when put together as a portfolio their volatility evens out.

4. Is volatility and risk the same thing?

No! They are often mistaken (or conveniently taken) to be, but that is far from the truth.

In his confession two weeks ago, Alvin explains how he sells options for regular income. The gains are small and consistent and hence volatility is relatively low for the majority of the time. But when the market suddenly experiences a decline, all the options he has sold will now become in-the-money and he would have experienced a massive drawdown. It is an extremely risky venture. This is a classic example of a low volatility – high risk venture.

But do not be mistaken now and start to equate low volatility with high risk, or high volatility with low risk. Academically, risk and volatility are independent.

5. So which one is more important to me as an investor, volatility or risk?

Both!

Knowing how risky your investment is means understanding what can go wrong and how much you could stand to lose if the investment goes bad. And by being aware, you can actively manage it by reducing lot sizes, putting in cut losses, hedging with other complementary assets.

Knowing how volatile your investment can be means understanding how the investment will fluctuate over time. Human beings crave for stability and certainty, and volatility plays on people’s emotions and causes them to lose sleep. Imagine an investment that loses 40% over a week and then reverses the losses and gains another 30% the next week. The despair and elation will cause the investor to make irrational decisions, possibly selling out of fear when the stock is plunging and kicking himself when it starts to rebound.

Conclusion

Know how volatile your investments are, and more importantly, know how much volatility you can take before succumbing to your emotions. If you have a weak heart but insist on going to the amusement park for rides, it might be a better idea to stay on the choo choo train rather than the roller coaster.



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11 Comments
  • ylfoo
    Posted at 11:29h, 23 July Reply

    Hi Jon,

    Thank you for the good article.

    Just to share something that I cannot figure out in your first sentence.
    “If the price of asset A moves more than asset B, asset B is considered more volatile. It is as simple as that.”

    I thought that asset A should be more volatile based on your reason?

    Look forward to more great articles from you.

    • Alvin Chow
      Posted at 07:00h, 25 July Reply

      Ha, let me help Jon answer this. He made a mistake. It should be Asset A is considered more volatile. Amended the post :D

    • Jon
      Posted at 13:10h, 25 July Reply

      Hi ylfoo, my apologies. It should mean the converse. Since edited. My apologies. Good catch on that one. And looking forward to hearing more from you too!

  • ryan
    Posted at 19:02h, 23 July Reply

    Thanks Jon for this article. It’s a very interesting subject. Allow me to pepper a bit more on this subject matter if I may. As an investor my risk in an investment is the risk of the projected future earnings stream. There can be a myriad of factors both external and internal that can influence this set of numbers. That is my investment risk because I’m buying a business and thus its earnings and cash flow matters to me as an owner. Now, let’s now assume this investment is a private company. Being a non listed entity, I would then not be subjected to the issue of volatility. It just doesn’t exist for me as the shares are not traded publicly.
    I think risk and volatility as you mentioned are not the same. In fact they are very different if you look at the private company example. Therefore how then should we view volatility or whether it matters at all? Volatility is the bearer of both fortune and misfortune. Normally volatility is high when the market is in a bearish state. When fear gains a foothold in the market psyche, prices can go south very fast leading to volatility spikes. When that happens, is that good or bad? When prices go down, the cost of entry into an investment gets cheaper and cheaper. Thus for an investor, its a good time to buy especially if there’s nothing fundamentally wrong with the company. Therefore period of high volatility can be good. Normally it is during those rare times of seemingly risky period that opportunity presents itself. If I am already invested, should I be worried? It depends on whether that future cash flow that I talked about earlier will be affected. Interestingly, I discover that we truly know whether we are an investor or not when share price go south. Falling prices have the tendency to question our true investing motive.
    Volatility is nothing more than the manifestation of price behavior. When it comes to price behavior, there’s one thing that I always tell myself. Price can go up for good reason, bad reason or no reason. The same applies when prices go down. And volatility is embedded in those price movement. The period when the market is most risky is when volatility is low and not when its high. Periods before major market corrections have always been period where volatility is low. Everyone feels good and gravy train just doesn’t look back.
    In sum, we need to define for ourselves our investing motive and then understand the difference between risk and volatility. Then figure out how we can capitalise on the opportunity when the crowd equates risk and volatilty as the same thing.

    • Jon
      Posted at 13:54h, 25 July Reply

      Well said ryan, well said indeed.

      If it is a non-listed entity there will be no volatility – agree. Unfortunately volatility is a necessary evil of liquidity. The stock market provides this liquidity and also incurs the volatility. Retail investors will find it tough to invest in private companies with only the project earnings steam as benchmark.

      Periods of high volatility is good – agree too. Unfortunately few see it in this manner because they would be focused on the current, already demolished price of the asset rather than the relatively unchanged earnings. Volatility is the one that cause people to lose sleep and wreck emotional havoc. How many have the grump to stay the course in periods of high volatility and huge price swings?

      Period when market is most risky is when volatility is low, not when it is high – totally agree. As traders we traded the index using VIX as an indicator. As an investor do you take meaning from the VIX as to when to invest? Do share more with us!

      • ryan
        Posted at 14:26h, 27 July Reply

        Hi Jon, I’ve never looked at VIX when deciding to invest. Looking at share prices in general, we can conclude pretty much how, VIX or implied volatility is behaving ie if prices go south, VIX will go up and vice verse.
        I strongly believe that the one subject that needs to be taught in business school is Economic History. It is also a subject never taught much in those investment classes outside. As we cannot foresee the future, history is our only guide. We can draw hypothesis from lessons in the past. Economic crisis, financial crisis, they pretty much follow the same blue print. Periods before, during and after crisis, they follow the same path. If we can understand what happened in the past, we can make better guesses in the present. The future will worry for itself. My entire investment thesis is based on history. However, I got to caution that one has to take a very long term view of things and events because crisis and its remedies, they don’t just happen in a flash. It takes time.

        • Jon
          Posted at 02:27h, 29 July Reply

          Economic history. Interesting indeed. Thanks for sharing!

  • Pok Chow
    Posted at 22:22h, 03 August Reply

    In options trading, we love volatility. Without volatility, we are being limited in the things that we do. So the more volatile the market is, the more aggressive we get.
    It is pretty opposite to the “conventional” understanding of investing where people look for stable underlying that wouldn’t give them a heart attack! When things get interesting, we step up our game!

    Thanks
    Pok Chow

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