Figures that show an average return on an investment are only part of the story. They don’t tell how that return was achieved. Is the investment a volatile one, with a lot of ups and downs in price or returns that varied dramatically? Or was its performance relatively steady, with prices and returns that were very similar month to month or year after year? Understanding volatility measures can help you evaluate whether a particular investment is suited to your own investing style. Volatility measurements can be used to evaluate the performance of mutual funds and investment portfolios as well as individual securities.
This figure measures how much an investment’s return varies from its mean return. The higher an investment’s standard deviation is, the more dramatic its ups and downs. For example, let’s say two stocks each return an average of 6 percent a year. However, one of those stocks might have a much higher return in some years, but lose a lot of value in others. That stock’s standard deviation from its mean would be quite high. The second stock might achieve the same average without such dramatic price swings, and would therefore have a lower standard deviation.
Another way to evaluate an investment’s volatility is to look at its beta, which compares an individual investment’s volatility to that of the market. A stock or mutual fund with a beta of 1.0 would have exactly as much market risk as its benchmark–for example, the S&P 500 stock index. A stock or mutual fund with a beta of 1.5 would involve 50 percent more market risk than the benchmark; if the benchmark went up, the individual security would be expected to go 50 percent higher. If the benchmark’s return dropped, the security’s return should be 50 percent lower. Conversely, a stock or fund with a beta of less than 1.0 would involve less market-related volatility than the overall market. If the S&P rose by 50 percent, an investment with a beta of 0.5 should benefit by only 25 percent. If the benchmark fell by 50 percent, the individual security with a 0.5 beta should experience only a 25 percent drop.
Beta as a measurement of volatility is useful only if the investment is being compared to an appropriate benchmark. R-squared measures how much of an investment’s volatility depends on the volatility of its benchmark. For example, the performance of an index mutual fund based on the S&P 500 would be almost entirely the result of the performance of the index itself. If an investment’s performance is perfectly correlated with that of the overall market, it would have an R-squared of 1.00. The lower the R-squared, the less the investment’s performance can be explained by the market’s overall performance. For example, a stock with an R-squared of 0.80 would mirror the performance of the S&P 500 index much more closely than a stock with an R-squared of 0.40, which would be much more affected by factors specific to that stock.
In addition to risk and reward that is linked to market movements, an investment involves risk and reward that is unique to the investment itself. A stock, for example, might benefit from superior management of the company, or suffer because of a substantial delay in launching an important product. Alpha indicates how well an investor is being compensated for the level of that specific (nonmarket-related) risk. It compares an investment’s returns to the performance an investor might expect given the level of risk indicated by its beta. A positive alpha would mean that for the time period measured, the investment has done better than the return that investors could have predicted simply by multiplying its beta figure times the return of the benchmark index. A negative alpha means just the opposite: that the investment’s returns have been worse than they should have been for the level of risk taken. At the portfolio level, alpha is a way to gauge whether you benefit from active management, compared to simply investing passively in an index.
Measuring Overall Market Volatility
One way investors sometimes try to gauge short-term volatility in the market as a whole is to look at the Volatility Index (VIX) created by the Chicago Board Options Exchange. The VIX is calculated as a percentage figure by averaging the prices of options on the S&P 500 index. The figure, which is calculated minute-by-minute based on ongoing options trading, is used to gauge investor expectations for market volatility over the next 30 days. Though past performance is no guarantee of future results, options prices tend to rise when the markets are in turmoil and investor anxiety is high. That pushes the VIX up as well. When investors are feeling more certain about the future, options prices and the VIX tend to drop.