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.
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.
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?
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.
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.