Retirement Investor: “Understanding Variability and Volatility and Why They Matter to Your Portfolio”
By Marguerita Cheng, CFP® Pro • CEO, Blue Ocean Global Wealth Management
If you are tired of the abundance of jargon in the world of finance, you are probably wondering why you should read an article about two words that typify this type of vocabulary: variability and volatility.
Now, I understand we get tired of them, but some words are so important that if we understand what they mean and how important they are, it is worth the time to embrace them. Variability and volatility are examples of two such words.
Understanding variability and volatility will help you make the right investment decisions. Knowing the meaning of these terms can make the difference between having a successful portfolio that minimizes risk and maximizes return and a failed portfolio that doesn’t meet your financial goals.
In this article, we consider the following:
- The place of risk in investment decisions
- What is variability?
- What is volatility?
- Variability, volatility, and risk premium
- Variability, volatility, and portfolio diversification
So, let’s explore these terms together.
The Place of Risk in Investment Decisions
To understand why these two finance concepts are important, we need to spend a moment considering the place of risk in investment decisions. “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1,” said Warren Buffett, the CEO of Berkshire Hathaway. In the investing world, keeping your money is as important as growing it since it is only money that is not lost that can be grown. The potential returns of an asset are irrelevant if you lose that asset. Therefore, the risk of an asset is as important as the returns.
Harry Markowitz developed the Modern Portfolio Theory to help investors combine risk and returns when evaluating potential investments. His development of the efficient frontier—a number of portfolios that provide the highest level of returns for a given level of risk—has revolutionized investing. Now, investors can measure risk and returns and choose a portfolio that minimizes the former and maximizes the latter.
A consideration of risk is especially important in retirement planning. The goal of retirement planning is to retire with a big enough nest egg to last till death. Investing in a juicy asset that promises high returns might sound enticing (enough money to go on vacation during retirement), but consider the downside: you lose all the money, and you have to retire on $0 (or something close to zero).
Financial advisers and wealth managers must also learn to consider the place of risk in investing. “What if your adviser talks only about returns, not risk?” William Sharpe, a Nobel Prize winner in Economic Sciences, once asked. “It’s his job to take risk into account by telling you the range of possible outcomes you face. If he won’t, go to a new planner, someone who will get real.”
So, why is any of the above relevant to the topic? Variability and volatility are standard ways of measuring the risk of an asset. They help investors understand the risk of an investment so they can compare it with the returns and make a smart decision.
Now, let’s get down to business.
What Is Variability?
Generally, variability is a concept that shows how diverse or spread out something is. For example, water coming from a tap has less variability, while the water coming from a shower has more variability. The former is coming out from one single point, while the latter comes out from various points.
In statistics, variability measures how much data points diverge or vary from one another or the mean.
If the marks of three students in a class are 52, 53, and 54, it shows less variability than if the scores are 52, 65, and 79. The latter is more diverse and spread out, ranging from 52 to 79, while the former only ranges from 52 to 54.
In finance, variability measures how spread out or diverse an asset’s returns are or are likely to be.
For example, let’s say Stock A has had past returns that include 10%, 50%, -15%, 1%, and 100%. It has higher variability than stock B, which has had past returns that include 10%, 15%, 20%, 25%, and 5%.
One important point to note here is that in the world of finance, investors use variability to define the nature or personality of an asset. Therefore, it is not a measure of how spread out or diverse an asset’s returns are over a defined period. Rather, it is a statement about the general nature of an asset’s returns. For example, stocks have higher variability than bonds, and mutual funds have higher variability than savings accounts.
Variability and Risk
How, then, is variability related to risk?
If an asset can have 10% returns today and 50% tomorrow, and then -15% the next day, it is riskier than an asset that will have 10% returns today, 15% tomorrow, and 20% the next day. The closer the returns of an asset to each other, the more predictable they are, and vice versa.
The less predictable an asset’s returns, the more the uncertainty, and greater uncertainty means greater risk.
Consequently, bonds, with more predictable and less diverse returns, are less risky than stocks, with less predictable and more diverse returns.
What Is Volatility?
Volatility is variability applied over a defined period. While variability considers an asset’s general nature and personality, volatility zeros in on a specific period. Consequently, we can measure the daily, weekly, monthly, and yearly volatility of an asset. In finance, volatility measures how much returns deviate from each other or from the mean over a defined period.
Click here to view a chart that shows the daily volatility of stocks (using the S&P 500 index) for selected days from 1928 to 2018.