Understanding volatility is one of the most basic aspects of investing. People who are building a retirement portfolio and plan to utilize those funds in the next few years may wish to avoid volatility to ensure their money is available when needed.
On the other hand, young people with long-term investment plans may be more willing to endure volatility with the goal of realizing major gains some time down the road.
What is Volatility?
Before attempting to understand how volatility is calculated it may be important to understand exactly what volatility is. Simply put, volatility is one tool used by investors to predict the amount of risk in a specific investment.
A high level of volatility means that there have been major swings between an investment’s high points and its low points. On the flip side of that, lower volatility suggests that an investment has been very consistent without large fluctuations in value.
Volatility is not necessarily good or bad. Specific investment plans may be more tolerant to volatility while others may avoid volatility as much as possible.
How is Volatility Calculated?
This is where the numbers get crunched.
Calculating volatility involves using historical data. Of course, no amount of historical data can provide a clear look into the future but past trends are often a good way to predict future behaviors in the investing world.
There are several ways to use the historical data available when calculating volatility. Most investment funds, advisors, and publications will provide the methods they use for calculating volatility. For example, Morningstar has a data definitions page on their website where they clearly outline the volatility calculations they implement.
One of the most common methods used for calculating volatility is standard deviation. The standard deviation can be used to calculate short-term volatility as well as long-term volatility. First, calculate the average price of a stock over the defined period. Then, use the actual price from each period to find that period’s standard deviation (actual price minus the average price).
For short-term calculations, you would look at daily closing prices. Then you will square the deviation for each period, add the results, and divide by the number of periods used for the data. The square root of the final sum is the standard deviation for that frame of time. The higher the standard deviation, the more volatility there is in an investment.
Of course, if that sounds complicated you can always use the STDEVP formula in Excel and let your computer do the work for you.
Volatility is Not Your Only Tool
Understanding volatility is important but it shouldn’t be the only tool used to determine whether an investment is right for your portfolio. Any measurement of data is only as good as the data provided.
We recommend looking at short-term and long-term volatility to get the full picture of what is going on with an investment.
With more information at your disposal, you will be able to make more informed decisions.