What is Volatility?

As we continue to define finance terms, we come to a term that is tossed around a lot lately: volatility. Generally, when something is volatile, it means that it is unstable and could at any moment take off in one direction or another.

The measure of volatility in finance is similar: it measures how much a stock is expected to vary over a period of time. But it is also a little more complex than that, so let’s look at everything that is involved.

Specifics about Finance Volatility

As we established, finance volatility measures the stock’s expected variance (as predicted by historical trends), and this can be measured as a percentage or dollar amount from the mean. The complex part comes about in the many different ways volatility can be measured and in the calculation.

Now the actual calculation for volatility is complex, including all kinds of square roots (and advanced math that I have long forgotten!), so we won’t discuss the measurement in detail. However, one basic term should be covered to better understand volatility: beta.

Beta

One common way to measure volatility is to compare it to a stock market index, like the S&P 500. The index that the stock is being measured against is called the beta. When this beta (in our example, the S&P 500) moves, the stock’s comparative move is measured against the beta to give the volatility as a percentage or an absolute number.

These numbers can be broken down to groups of stable or volatile. Stable stocks will vary little from the beta, and volatile stocks will reflect a volatility of at least twice the value of the beta.

For example, let’s look at one of my favorite stocks, General Mills: it has a beta value of 1.08% against the S&P 500. This means that for every 100% move the S&P 500 made, General Mills moved 108%. These figures mean great things for the volatility of General Mills; the stock is relatively stable. On the other hand, a volatile stock would measure closer to 2% (or higher).

Using the Information

So now that we’ve defined volatility, how can we use it to our advantage? Typically, the more volatile the stock, the more dangerous the investment. If a stock swings in huge variances on any given day, you can never really predict what direction it is going.

Stocks with low volatility, on the other hand, will be more predictable. For long term stocks, lower volatility is generally favored. These stocks are sure and steady; they will be much more likely to win the race. It will just take a little longer to get there.

That being said, if you wish to make money quickly, high volatility stocks are one of the only ways to go. The huge fluctuations allow you more chances to buy low and sell high. But the volatility also leaves you with an unstable stock that may not return to a selling point. We here at MomVesting would like to caution: it is better to buy healthy stocks for the long haul than to aim for quick money.

Volatility is a very important term with which you should become familiar. It allows investors to better identify stable stocks. However, it is only a small part of the stock’s overall health, so be sure to consider all other parts of the stock and the business before purchasing.

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Anonymous's picture

MoneyCone wrote:

Mon, 05/23/2011 - 18:57 Comment #: 1

Understanding beta is very useful when you look at a stock you are not familiar with. If the market is chopping, will give you an idea how the stock might perform short term.

Nice writeup Christa!

Anonymous's picture

Alex | Perfecting Dad wrote:

Tue, 05/24/2011 - 13:33 Comment #: 2

Nice intro Christa! I assume that later (or maybe you already have been) you will be talking about portfolios. This volatility math you describe is exactly why portfolio theory was invented. Portfolios are a main way to reduce your volatility by averaging a basket of stocks instead of just one.

Also, another name for volatility is risk. A bank account that always returns a steady 1% is not risky. Another stock that returns, on average, 1% but swings wildly from +50% to -50% on any given day is highly risky. Even though they both pay the same, long term, you take the bank account because it is more certain. People say you should "Get paid for risk" meaning that a risky stock needs to pay out much higher than a stable stock.

That's also a reason why the banks charge different people different rates. If you're a boring customer who pays on time every time then you get a low boring rate. But if you're a volatile risky customer who falls behind, then catches up, racks up tons of debt, then pays it off, well that's a risky customer who needs a higher interest rate for the bank to be satisfied.

Anyway, to your conclusion: You do need to go riskier to get paid more, but not all riskier investments actually do pay more. This is where a lot of people go wrong, especially in the stock market. As you said, everything is indexed to the market return and everyone knows about portfolio theory. Therefore, if people purposely buy themselves a few risky stocks then they probably will not be paid for that extra risk because the market has been priced, through arbitrage, such that reckless risk is not rewarded. People are expected to know how to build something close to an "optimal" portfolio for the amount of risk they want to take. Can't wait to read your articles about that!

Christa Palm's picture

Christa Palm wrote:

Thu, 05/26/2011 - 18:34 Comment #: 3

MoneyCone, very true about comparing a stock to the beta when the market is down: you can better predict how your stock will do in the short term.

Perfecting Dad, thanks for all of the comments! You have some awesome points. We'll definitely write up a specific portfolio post at a later date :-)

Anonymous's picture

Guide to Financial Trade: Strategies and Styles | howtotrade wrote:

Fri, 09/02/2011 - 17:22 Comment #: 4

[...] Volatility Measures How Stocks Vary Over Some Time [...]

Anonymous's picture

Financial Definitions - Glossary for Understanding Finances wrote:

Thu, 01/19/2012 - 21:47 Comment #: 5

[...] V Vested Balance Volatility [...]

Anonymous's picture

Everything You Need to Know about Stocks | MomVesting wrote:

Thu, 01/19/2012 - 21:47 Comment #: 6

[...] What is stock volatility? Find out how variability affects your stocks. [...]

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