What Is Volatility and How Is It Calculated?
Each time you make an investment decision, you’ll want to know how risky your investment is. Volatility is a metric that can be used here, as it reflects how much the stock has fluctuated in the past. Let’s find out more about how this can be used when making your own investment choices.
Understanding volatility is part of the job of an investor. It will help you understand how risky an investment is, meaning you can know whether it fits your portfolio and your risk profile.
Those closer to retirement may want to avoid volatile stocks due to the increased risks, whereas younger investors may be happy to weather the potential storm.
What exactly is volatility?
The volatility of a stock refers to how risky an investment is, specifically how much it is likely to fluctuate in price. Less risky stocks will be more stable in their price, whereas riskier stocks may go up and down rapidly in value over just a few days.
Understanding volatility involves looking at the historical data of the specific stock. Whilst this doesn’t guarantee an insight into the future, it is generally a good indicator of what the stock is all about.
“Buy not on optimism, but on arithmetic.” - Benjamin Graham, Investor & Mentor to Warren Buffett
There are many different methods for calculating volatility, and many firms publish their specific techniques online. However one of the most common ways to calculate both short-term and long-term volatility is to measure standard deviation.
First, the average price of the stock is calculated over the defined time period. Then, the actual price from each period is used to find that period’s standard deviation (i.e. the actual price minus the average price).
If you’re looking to run these calculations yourself in Excel, you can use the STDEVP formula.
Is that all I need?
It’s definitely important to understand volatility, but it's not the only tool you should use when deciding whether or not to invest.
It’s always good to start by looking at short-term and long-term volatility. Once you’ve done this, take in as many metrics as possible before you make a decision on whether a stock is the right choice for you.