Volatility might be one of the most basic financial concepts, but it’s often misunderstood. Fluctuations in the price of an investment is important for growth, and a natural element of the financial markets.
Here, we’ll break down the meaning of volatility, and explain its implications for investors.
A good starting point is probably its definition; market volatility measures how much an asset price changes over time.
High volatility means the price of an asset is likely to change dramatically over a short time frame, whilst low volatility indicates an asset’s price will be relatively stable.
Calculated in percentage points, you can measure volatility either through the standard deviation, or by comparing the volatility of an asset’s returns against the relevant benchmark – known as its beta.
Standard deviation is calculated by working out the square root of the difference between an asset’s price and its mean value. The higher the standard deviation, the more volatile the stock.
Does volatility measure risk?
Essentially, volatility calculates the risk associated to the value of an asset; the higher the volatility the more likely its value will fluctuate in either direction.
If you’re looking for big returns, you’ll want volatility exposure, although you’ll need a long-term time horizon to ride out any short-term losses.
A longer time-frame should also prevent you from making any knee-jerk reactions that could diminish your return potential.
Not everyone has the time or the temperament to see their investments rise and fall, which is why it’s important you understand your risk tolerance before you start investing. You can learn about your unique investor profile here.
Usually, investors who aren’t big fans of risk should opt for less volatile portfolios, but this could restrict your potential for returns.
How can you limit the effects of volatility?
To ensure your portfolio has been built with the right level of volatility exposure to help you achieve your goals, you need to take the time to outline your financial objectives and time horizon before you start investing.
Although some people try to time the markets, not many can do it successfully. We believe adopting a long-term strategy can help you achieve your financial goals by tailoring your portfolio around medium to long-term economic trends.
You can also manage volatility risk through a well-diversified portfolio. By balancing volatile assets with those that have more stable pricing, you’re likely to smooth out any fluctuations in returns.
Ultimately, volatility is neither wholly positive or negative. By taking the time to understand your financial needs, you can use volatility sensibly to help you reach your financial goals.