What is... | July 1, 2014

What is volatility?

An explosive is volatile: it can suddenly change from being safe to dangerous despite only a small change in conditions. The same can be true in financial markets.


For certain shares, bonds and other financial instruments, the price can change suddenly and with little warning.This is called "volatility", and investors should be especially careful.

High or low volatility? It depends how prices have moved
Volatility measures the risk of the price of an investment changing quickly. It measures the chances the price of a share, bond or other financial asset might change from one day, week or month to the next, between two specific points in time. A share that rises 10% in price over a year can display either high or low volatility depending on how the price moved over that time.

If the price of the share increases a little each day, by the end of the year rising 10%, the share may be said to have low volatility. But if its price rises a lot for a few weeks and then falls for a while and does that throughout the year, finishing as a rise of 10%, the share is said to have been highly volatile. (Obviously, the same is true if it ends the year down 10% – it may have low or high volatility).

Volatility is not the same as risk (but they are linked)
Investments that are highly volatile are often described as “high risk” because there is more chance of losing money. On the other hand, finance specialists may be able to estimate the price of the low-volatility share in the example above with confidence, throughout the year.

If an investor had to sell the high volatility share during the year, there would be a greater chance of losing money than with the low volatility share. Investors usually require a higher potential return to choose these investments.

Cash or money held at a bank usually gives steady, low-volatility returns and carries less risk of loss. As a result, the returns offered are usually lower than investments in bonds, property or shares, each of which are more likely to be volatile.

Volatility and maths
In mathematical terms, volatility is the standard deviation of the change in price from one day, week or month to the next over a particular time. Volatility is usually expressed as a percentage which may change depending on the time period over which it is measured. Cash usually has low volatility, close to zero.

An index of government bonds may have volatility over a period of five to ten years of around five percent or less. A share index (such as the German DAX or the US S&P500) is typically more volatile at around 13% to 18%. The exact values will differ between countries, the index being measured and the time period over which the calculation is made. The Vix index is an accessible measure of volatility in US and global share markets, often cited in the financial press.

Technically, the Vix calculation differs from the usual approach. It reflects how US shares are expected to move, based on option prices rather than how prices have actually moved in the past – and it focuses on a short period of 30 days.

Volatility is not the only risk
Volatility does not account for all investment risk. Other risks may include liquidity risk (not being able to access your money if it is needed quickly) and counterparty risk (an institution holding the investment getting into financial difficulty or defrauding investors). For international investments, exchange rate risk (or the risk that exchange rates may move against you) is also a factor.

If an investment has low volatility, this does not necessarily mean it is safe. For example, some investors in the 2008 Madoff scandal were attracted by the consistent low volatility of returns from the fund, only to suffer big losses when fraud was uncovered.

Keeping control
Volatility can affect the way people react to investment. Those able to control their emotions and with sufficient wealth to sustain large price movements may prefer high volatility investments. Others may prefer the relative security and emotional calm of lower volatility investments.

InvestingSharesRisk

eZonomics team
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