What is volatility?
Volatility definition can be short: volatility is the size of the amplitude in investment’s value changes over time. In simple words, it describes the riskiness of the security because if the price of an investment tends to rise and fall more than of others, investor is facing higher risk which is related to volatility. All investments including stocks have different volatility: some of those fluctuate more in prices some less. Those securities that change their value in higher amplitude have higher volatility.
How to measure volatility
The measurement of volatility uses statistical data for calculations. The most common measure of volatility is standard deviation of the security prices, but variance instead of standard deviation can also be used, though is not so popular. Standard deviation can be calculated for different periods of stock’s price return. The most popular periods for standard deviation returns are: annual, monthly and daily. The standard deviation of these different periods tells us different information and all of them can be used together. But the period is the key for this ratio. If investor calculates annual standard deviation only for three of four years, it will be useless because such period is too short. Another common mistake is to compare standard deviations that were calculated using data from different periods.
When volatility of stocks or other investments is compared, it (standard deviation or other ratios) must be calculated for the same period (for example, from 2001-2012) and would be great if that period would include full economical cycle.
Another very popular investment’s risk measure is beta which shows relative volatility in relation the whole market.
Volatility in investment
Volatility is one of three main characteristics of every investment. For any investor volatility simply means the riskiness of an investment. If volatility of the stock is very high, it means the riskiness of this stock is very dangerous. But it does not mean that every volatile investment is bad, while such investments may have higher return potential.
To understand the riskiness of the securities in his portfolio correctly is the most important thing about volatility in investment. If stock price did not change significantly over few last months, it does not yet mean that volatility is low, while such stock can move rapidly in any directions if some circumstances occur and every investor have to be aware of this.
Volatility of every investment in the portfolio determines the riskiness of the total portfolio. It is one of the most important things that the riskiness of total portfolio would meet the risk tolerance of the particular investor correctly.
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