The ups and downs of volatility
Joel Dresang: Steve, let’s go a little deeper on a term that we use from time to time: Volatility, or the fluctuation in the value of investments. Why is that so important?
Steve Giles: Well Joel, volatility is important because it’s a way for us to measure risk. Volatility will look at how much a particular investment will slide up or down in a given day, or over a given period of time. The reason why this is important for investors is because we have to gauge how much risk we’re willing to put up with in order to achieve our goals longer term.
Joel: What causes volatility?
Steve: Well Joel, a couple of things. On the downside, you certainly have something like fear. The more afraid people are of investments, the more they’re willing to disengage, and that’s going to pull assets down in price.
You also have uncertainty. Consider the Brexit vote last summer, when everybody was uncertain about the outcome of how that was going to play out, when Britain voted to remove themselves from the European Union.
On the upside volatility – which cuts both ways – you’ve got greed. The more investors are willing to pile into an investment, the higher that that price is going to go up.
Joel: So, how do you measure volatility?
Steve: Well Joel, volatility is measured by looking at the frequency with which an investment may trade up or down during a particular time period. Take the S&P, for example. We can gauge the S&P 500’s volatility by looking at how many up or down movements the index had greater than 1% over a given time frame. But that’s an historical look back.
The VIX, the volatility index, also called the fear gauge, looks at how much investors are expecting to see heightened volatility over the next 30 days.
Joel: So, those are looking at the broader market. What about individual investments?
Steve: Well Joel, with individual securities, we need to have something to compare them to, to gauge their volatility. The biggest measure that we use is something called beta.
If we want to gauge how risky an investment is, or how volatile an investment is, we want to compare that with beta to a particular index. Take the S&P, for example. If we assign the S&P a beta of 1 and we have an investment with a beta greater than 1, you would expect that that investment is going to be more volatile than the index. Conversely, if that investment has a beta less than 1, you would expect that its volatility will be less than the S&P 500.
Joel: And there’s also the standard deviation.
Steve: Sure. Standard deviation is a way to track historically, how volatile an investment has been. If you have two investments that annualized an 8% return over a 10-year time frame, but the first investment had a much higher standard deviation, that was the more risky investment.
Joel: So, what does volatility mean for long-term investors?
Steve: Well, fluctuations in your investments can make you nervous in the short term. And anything that you know you’re going to need in the short term shouldn’t be in something that fluctuates wildly.
I think it’s important for us as investors to have some balance in our portfolios. You want to make sure that in order to achieve your longer-term goals by owning assets that have a higher appreciation potential, that of course have higher volatility, you need to couple that with something that’s going to give you much shorter term cash flow needs.
Joel: How do you convince investors to put up with volatility?
Steve: Well, I think you have to consider it as part of your portfolio overall. At the end of the day, Joel, it all comes down to balance. Recognize that you’re going to need something for the longer term growth in your portfolio. It will be more volatile. But also recognize that the short-term investments in your portfolio are going to give you the courage to own that long-term growth in the first place.
Risk: How much can you stand? How much do you need? a Money Talk Video with Isabelle Wiemero
Beta: Learning how risky an investment might be, a Money Talk Video with Kyle Tetting
Volatility: What investors should know, a Money Talk Video with Marc Amateis
What investors need to know about volatility, from the Financial Industry Regulatory Authority
Your one-minute guide to stock volatility, from the Financial Industry Regulatory Authority
(initially posted June 2, 2017)