Volatility
Volatility measures how much an investment swings. It's a useful but incomplete measure of risk, because it treats swings up and down the same.
Learning objective: After this lesson you can explain what volatility measures and why it's an incomplete measure of risk.
Volatility tells you how much a price swings around its average. High volatility means big moves in both directions. A broad stock ETF typically swings around 15 to 20 percent a year, Bitcoin more like 50 to 80 percent.
Volatility is not risk
Volatility is often equated with risk, and that's only partly right. A price that jumps sharply upwards has high volatility, but nobody would feel that as risk.
Permanent loss
What volatility also doesn't capture is the danger of a permanent loss. A company sliding slowly and steadily into bankruptcy has low volatility and still the greatest risk there is.
Still useful
It's still useful, because it can be measured and compared. Just read it together with other figures, above all the maximum drawdown. That shows what people actually had to endure in the past.
Volatility is usually given as the standard deviation of returns, scaled up to a year. To do that, you multiply the daily fluctuation by the square root of the number of trading days, so by about 16. That only works well if the returns of individual days are independent of each other. For investments that are valued rarely and smoothly, such as some property funds, that's not the case. There the calculation clearly underestimates the real fluctuation.
Swings in both directions
Standard deviation rates swings up and down the same. There are measures that only look at losses. Value at risk tells you what loss you won't exceed on a normal bad day, for example on 95 days out of 100. Better is expected shortfall. It tells you how big the loss is on average on the remaining, truly bad days, and so looks exactly at the place that can ruin you.
Clustered swings
Swings come in clusters. Turbulent phases are usually followed by more turbulent ones, calm ones by calm ones. That's why volatility can be forecast quite well in the short term, while the direction of the price can't. Something useful follows: managing your risk is easier than predicting returns.
Summary
- Volatility treats swings up and down the same.
- It doesn't capture the danger of a permanent loss.
- Volatility can be forecast, the direction of the price can't.
Did you get it?
Why is volatility an incomplete measure of risk?
Because it treats swings in both directions the same and doesn't capture permanent losses.
When does the usual calculation underestimate fluctuation?
For investments valued rarely and smoothly, because returns there aren't independent.
What does it mean that swings come in clusters?
Turbulent phases are usually followed by more. That's why volatility can be forecast in the short term.
Check your understanding
Your task
An asset moves 2 percent per day. Scale that to a year by multiplying with the square root of 252 trading days (about 15.9). Compare the result with the 15 to 20 percent of a broad stock ETF and then take a look at the drawdown calculator.
Sources and further reading
- Robert Engle's original 1982 paper introducing the ARCH model used to describe volatility clustering. View source ↗
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- What return actually meansStage 1
- Hedging with optionsStage 5
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