What Is Investment Volatility?

The term “volatility” is commonly used by investment commentators. What exactly do they refer to, and, although it sounds nasty, how should you deal with it? Or should you avoid it as far as possible?

Volatility is a statistical measure of the extent to which the price of an asset fluctuates over time. The term is generally associated with assets such as shares, commodities and currencies (including crypto), where the price can change from one moment to the next. It also applies to market indices tracking these asset classes and to associated derivative instruments.

Lows and highs may be within a wide or narrow range. Here are two sets of numbers with the same mean, or average, of 8:

Set A: 3, 10, 14, 4, 12, 1, 8, 15, 2, 11.

Set B: 11, 8, 9, 4, 8, 10, 6, 9, 5, 10.

As you can see, Set A is more volatile, with numbers deviating further from the mean. The lowest number is 1 and the highest is 15, with a difference of 14. In Set B, the numbers cluster around the mean of 8. The lowest number is 4 and the highest 11, with a difference of 7.

Investment volatility is determined using statistical measures of variability around the mean (variance and standard deviation) within a given time frame, such as a year. It is often expressed as a percentage. For example, if a share has a volatility of 10%, the price may potentially deviate from its average by 10% up or down within a year.

Implied volatility measures how volatile the market is expected to be, while historical volatility tells you how volatile the market has been in the past.

What causes volatility?

Some asset classes are naturally more volatile than others. Equities are more volatile than bonds but less volatile than cryptocurrencies. Within asset classes, sub-classes may have higher or lower volatility. Small-cap shares are generally more volatile than large-cap shares, for example.

The overall level of volatility in a market, however, is a function of uncertainty. When the economy is running smoothly, investors can make more accurate assumptions about performance. It’s when investors are uncertain about the direction of asset prices that volatility rises. This may be when an economy falters or when geopolitical events threaten to disrupt it.

A popular measure of uncertainty and implied volatility on the US equity market is the Chicago Board Options Exchange Volatility Index, known as the VIX. This is a measure of  the 30-day expected volatility of the US stock market derived from quotes on options linked to the S&P500 Index. (Options are derivatives that involve “betting” on the future price of a share.) A high VIX signals high volatility and uncertainty (and fear).

The chart of the VIX over the last two decades shows that volatility peaks during a financial crisis – the three peaks circled in red represent the height of the 2008 global financial crisis after Lehman Brothers collapsed, the start of the Covid-19 pandemic in 2020, and US President Donald Trump’s “Liberation Day” in 2025, when he threatened tariffs on America’s trading partners.

Is volatility an investment risk?

For short-term investors and traders, volatility presents opportunities to buy assets at low prices. However, for long-term investors, and particularly investors drawing an income from their investments, volatility is a risk that needs to be managed.

In his book “The Effective Investor”, investment guru Franco Busetti says it’s broadly true that, over the long term, volatility is rewarded with high returns, although this relationship does not always hold over the short- to medium term.

He says there are two ways to manage (and benefit from) volatility in higher-risk assets such as equities: through portfolio diversification and time diversification. Time diversification is, essentially, time in the markets. The longer the investment term, the lower the diversification of returns becomes, as long as you remain invested.

“Bad events such as materially negative returns or a drop in your portfolio’s value are inevitable statistical manifestations of volatility. Do not panic and remain invested. Over the whole period the outcome will be much better,” Busetti says.

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REFERENCES/SOURCES

https://www.businessinsider.com/personal-finance/investing/what-is-volatility

https://www.investopedia.com/terms/v/volatility.asp

https://en.wikipedia.org/wiki/VIX

“The Effective Investor” by Franco Busetti (Roller Bird Press, 2009)