Investment Volatility and Beta

The term investment volatility is generally used to refer to how much the price of an asset varies between periods.  The typical period is normally a day, but it can also be weeks (weekly volatility) or months (monthly volatility).

There are several ways to measure volatility.  One such way in the case of a stock is to refer to its beta.  The beta measures how much the stock moves on a typical day when compared to the overall stock market.  We usually use a proxy to measure the market, in the form of an index such as the S&P 500 index or the Dow Jones Industrial average.

For example, let’s say our stock is called Volatile Inc. and it has a beta of 2.5.  This means that on a typical day, when the market goes up by 1%,  Volatile Inc. will go up by 2.5%.  But this works both ways:  on a 1% down day in the market, Volatile Inc. will typically lose 2.5%.  In other words, this is a risky stock and so we say it is volatile.

Relative Investment Volatility

Although a useful measure, beta is only a relative measure.  It tells us by how much more (or less) our stock will typically move compared to the market average.  Other than as a relative measure when compared to a stock market index, beta doesn’t tell us much about the risk that we may undertake by purchasing that stock.

Here’s a case in point:  during the 2008 financial crisis, the S&P 500 index had a maximum drawdown exceeding 50% – meaning that it lost over 50% of its value.  Now that’s what I call risk!  Of course, a stock with a beta of 2.0 would have lost twice as much, roughly equivalent to a drawdown of 75% (not a fun ride).  So a high beta does tell us we are taking on more risk than the market, but it doesn’t tell us much about how much money we may actually lose!

There are other and more useful ways to express investment volatility, using more absolute terms.  Wikipedia has a page describing investment volatility from a mathematical perspective, including details on the standard deviation.  I have written a separate post on standard deviation, where I provide some details while keeping the math to a minimum so it’s easier to understand.  The standard deviation is a very useful and important way to measure investment volatility because unlike beta, it provides a more absolute measure of risk.

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