Volatility as a Key Driver of Investment Process

Volatility can be defined as a measure of the historical rate of change for prices (realized volatility) and/or the market’s expectations for future price fluctuations (implied volatility).

Volatility is related to, but is not synonymous with, risk. Risk is the calculated result of the probability of a potential event multiplied by the impact of the event. Risk is generally associated with an undesirable outcome, such as loss of capital or impairment. When volatility is used to measure uncertainty, the result could be due to a positive outcome. Investors often overlook this important difference and its implications on their portfolios’ returns and wealth. Uncertainty is a result of an unknown probability of an event multiplied by unknown consequences of the event.

The prudent investment process should incorporate volatility analysis on an individual security and portfolio level. There are several strategies that can be employed to reduce the volatility of an investor’s portfolio. Regardless of the technique used, properly managing the portfolio’s volatility may reduce the potential for large negative returns.

Uncertainty is inherent in every financial model. It is driven by changing fundamentals, human psychology, and the manner in which the markets discount potential future states of the macroeconomic environment. The starting point for every financial process is the uncertainty facing investors, and the substance of every financial process involves the impact of uncertainty on the behavior of investors and, ultimately, on market prices. The very existence of financial economics as a discipline is predicated on uncertainty.

There is a common sense, that investors are usually rewarded in the long term. Building portfolios that have the ability to ride out the market’s ups and downs can help investors stay invested through the market cycle, benefitting from stronger long-term returns.

Standard deviation is the typical statistic used to measure volatility. Standard deviation is simply defined as the square root of the average variance of the data from its mean. While this statistic is relatively easy to calculate, the assumptions behind its interpretation are more complex, which in turn raises concern about its accuracy.

An alternative is to use VIX Index, the CBOE Volatility Index. It is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It’s sometimes called the “fear gauge”. Volatility refers to the amount of uncertainty in the size (and direction) of changes in a security’s value and is typically measured by the deviation of returns.

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