What is Volatility?
Volatility is the change in the performance of an investment over time.
Volatility is calculated by measuring the standard deviation in the return of an investment, and it is often used to calculate an investment’s risk.
Defining Volatility in Simple Terms
Volatility is one of the most important factors an investor takes into consideration when managing their portfolio and evaluating new investments.
For this reason, many metrics compare a unit of return against a unit of volatility, such as the Sharpe ratio, information ratio, and tracking error.
Investors expect to be compensated extra for additional risk they incur.
Probability of Permanent Loss
While volatility is the change or swing in an investment’s returns, risk is the probability of permanent loss.
Volatility becomes more closely related to risk when investors are planning to sell in the shorter term.
For example, investors closer to retirement may be forced to sell stock in order to pay for their expenses and are therefore more averse to volatility.
Warren Buffet on Volatility
Long term investors, however, do not associate volatility with risk as closely, and are, in general, more resilient.
Warren Buffet, a famous long-term investor, stated the following about volatility:
“Charlie and I would much rather earn a lumpy 15% over time than a smooth 12%.”
Large Cap or Small Cap?
Larger market cap stocks are generally less volatile than smaller companies because the amount of market activity needed to move that stock’s price is typically greater.
This is why larger companies often have less perceived risk than smaller companies.
Investors use a variety of methods to calculate volatility, including the standard deviation of returns, beta coefficients, and option pricing models such as the Black Scholes method.
In each case, an investor seeks to understand the degree that a security’s price fluctuates, either to minimize risk or maximize return.