RiskMetrics - Volatility


Volatility

Learn how to interpret standard deviation as a measure of volatility

Understanding volatility

In the financial world, risk is often expressed as volatility of returns. Volatility measures how variable outcomes are likely to be. For example, when you throw a dice, you know that the result will range from one to six. Similarly, when you buy an investment, its price volatility characterizes its range of returns.

Standard deviation

Standard deviation is a general statistical measure of volatility. It measures historical variability of returns from their mean. A higher standard deviation implies more variable and uncertain returns. Standard deviation has been a classical portfolio risk measure since Nobel laureate Harry Markovitz used it in the 1950s to demonstrate risk reduction through diversification.

Interpreting volatility

Given that in 1999 the daily standard deviations of returns for the S&P 500 Index and Yahoo! were 1.1 % and 5.6 % respectively, one can venture that Yahoo! was a much riskier investment than the S&P 500 Index. In fact, Yahoo!'s returns were around five times (or precisely 5.6/1.1) as volatile as the S&P 500 Index. But if Yahoo! was five times riskier, why did it outperform the S&P by 229 %? That's because risk cuts both ways.

Risk and return

Investing in Yahoo! stock means that you are more likely to experience sudden large drops in value, but you also stand a chance to achieve a higher return. Go ahead and compare Yahoo!'s biggest daily return and drop (+13.5 % and -23.5%) against the S&P 500 (+2.8 % and -3.5 %) in the table below. Higher volatility means higher gains AND losses. You can see the same pattern when you look at General Electric (GE) a more stable Blue Chip that isn't as risky as Yahoo!, but is still much riskier than the diversified S&P 500 Index.

Investment 1999 daily standard deviation 1999 return 1999 biggest daily upswing 1999 biggest daily drop
S&P 500 Index 1.1% 19.6% 2.8% -3.5%
Yahoo! stock 5.6% 248.9% 13.5% -23.9%
GE stock 1.8% 55.8% 5.8% -4.4%


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