Understanding Market Volatility
Understanding the volatility and risks involved with the markets is vitally important to maintain both your investment and emotional health. Chasing performance or trying to guess tops and bottoms in share prices is emotionally unhealthy. There are common measurement indicators that can help you quickly assess the volatility of a stock or mutual fund and whether it is appropriate for your investment strategy.
Beta
Beta is a measure of a stock (or a fund's) volatility in relation to a related index, usually the S&P 500 index. For example, the S&P 500 has a beta of 1.0. Individual stocks (or funds) are ranked according to how much they deviate from the index. A stock (or fund) that swings more than the index over time has a beta above 1.0. A stock (or fund) that moves less than the index has a beta less than 1.0. On average, high-beta stocks (or funds) are more volatile, but provide a potential for higher returns; low-beta stocks (or funds) pose less risk but also provide lower returns. A stock (or fund) with a beta of 1.5 means that it is 50 percent more volatile than the index. So a 10 percent rise in the index would be expected to result in a 15 percent rise in the stock (or fund). On the reverse, a 10 percent drop in the index could mean a 15 percent drop in the stock (or fund).
Note: Be aware of the fact that beta by itself is limited and can be skewed due to factors other than the market risk affecting the stock's (or fund's) volatility.
Alpha
Alpha is the performance of a stock (or fund) that is not explained by the beta. In other words, alpha is a measure of the difference between a stock's (or fund's) actual return and its expected performance as measured by beta. A high "beta" strategy in a rising market may produce returns substantially above the benchmark, but may generate negative alpha. Alpha and beta are independent contributors to returns and should be evaluated separately. Alpha can be created in two ways, through security selection and through market selection and benchmark timing. Benchmark timing is the process of actively managing beta.
Standard Deviation
Standard deviation measures a stock's (or fund's) risk, not with the index, but with its own average performance. A stock (or fund) that has a consistent four-year return of 3 percent, would have a mean, or average, of 3 percent. The standard deviation for this stock (or fund) would then be zero because its return in any given year does not differ from its four-year mean of 3 percent. On the other hand, a stock (or fund) that in each of the last four years returned -5 percent, 17 percent, 2 percent and 30 percent will have a mean return of 11 percent. The stock (or fund) will also exhibit a high standard deviation because each year its return differs from the mean return. This stock (or fund) is therefore more risky because it fluctuates widely between negative and positive returns within a short period.
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Beta
Beta is a measure of a stock (or a fund's) volatility in relation to a related index, usually the S&P 500 index. For example, the S&P 500 has a beta of 1.0. Individual stocks (or funds) are ranked according to how much they deviate from the index. A stock (or fund) that swings more than the index over time has a beta above 1.0. A stock (or fund) that moves less than the index has a beta less than 1.0. On average, high-beta stocks (or funds) are more volatile, but provide a potential for higher returns; low-beta stocks (or funds) pose less risk but also provide lower returns. A stock (or fund) with a beta of 1.5 means that it is 50 percent more volatile than the index. So a 10 percent rise in the index would be expected to result in a 15 percent rise in the stock (or fund). On the reverse, a 10 percent drop in the index could mean a 15 percent drop in the stock (or fund).
Note: Be aware of the fact that beta by itself is limited and can be skewed due to factors other than the market risk affecting the stock's (or fund's) volatility.
Alpha
Alpha is the performance of a stock (or fund) that is not explained by the beta. In other words, alpha is a measure of the difference between a stock's (or fund's) actual return and its expected performance as measured by beta. A high "beta" strategy in a rising market may produce returns substantially above the benchmark, but may generate negative alpha. Alpha and beta are independent contributors to returns and should be evaluated separately. Alpha can be created in two ways, through security selection and through market selection and benchmark timing. Benchmark timing is the process of actively managing beta.
Standard Deviation
Standard deviation measures a stock's (or fund's) risk, not with the index, but with its own average performance. A stock (or fund) that has a consistent four-year return of 3 percent, would have a mean, or average, of 3 percent. The standard deviation for this stock (or fund) would then be zero because its return in any given year does not differ from its four-year mean of 3 percent. On the other hand, a stock (or fund) that in each of the last four years returned -5 percent, 17 percent, 2 percent and 30 percent will have a mean return of 11 percent. The stock (or fund) will also exhibit a high standard deviation because each year its return differs from the mean return. This stock (or fund) is therefore more risky because it fluctuates widely between negative and positive returns within a short period.
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posted by Bob Moser at
5:52 PM
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