While every investor has some concept of risk, such as losing money. A stricter definition of risk is volatility, the measure of the fluctuation, either up and down, against a particular benchmark or to its own performance. Thus, volatility is quite natural and isn’t necessarily a bad thing; it’s simply one tool investors can employ to position themselves advantageously.
Volatility can be calculated on a yearly, monthly daily or any other time basis. A commonly used metric is the standard deviation. As an example, compare two companies’ returns over 10 years:
To find the standard deviation, average all values of the yearly returns. Next, subtract the average from each value and obtain the difference between individual observations and the average, also known as the mean. Then square these differences and add up the resulting squares. Finally, divide this sum by the number of values minus one and calculate the square root of the result, which equals the standard deviation. The standard deviation for Company XYZ is 20.68%; for Company ABC 1.29%.
Interpreting standard deviation
Standard deviation measures how much an investment can vary from its average return. It measures historic volatility and thereby gives investors a sense of how risky a future investment would be. The higher the standard deviation is, the greater the volatility and the risk. In this example, two companies have identical average returns, but one is far more volatile than the other. While this formulation reflects historic volatility, the Chicago Board Option Exchange has a Volatility Index, known as VIX, which projects future performance based on put and call options.
What this means for you
Volatility, implying risk, is but one factor an investor should consider. Much depends on where you are in your life. Volatility may be less of a factor for a younger individual; dramatic downward spikes in the market typically are followed by upswings that not only recoup any losses but also provide greater buying opportunities. On the other hand, if you’re nearing retirement age, you indeed may well choose to avoid volatility.
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The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the securities mentioned. The information contained herein, while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable. Opinions expressed herein are subject to change without notice.