Many investors realize that the stock market is a volatile place to invest their
money. The daily quarterly and annual moves can be dramatic,
but
it is this volatility that also generates the market returns
investors
experience.
Volatility
is a
measure of dispersion around the means
or average return
of
a security. One way
to measure volatility is by using the standard deviation, which
tells you how tightly the price of a stock is grouped around the means or
moving
average (MA). When the prices are tightly bunched together, the standard
deviation is small. When the price spread apart, you have a relatively large
standard deviation.
For securities, the higher the standard deviation, the greater the dispersion of
returns and the higher the risk associated with the investment. As described by modern portfolio theory (MPT), volatility creates risk that is associated with the degree of dispersion of returns around the average. In other words, the greater the chance of a lower than expected return, the riskier the investment. (For more
insight, real modern portfolio theory: why
it is
still hip and find the highest return with the sharp ratio.
Another way to measure volatility is to take the range of each period, from the low price valve to the high price valve. The range is then expressed as
a percentage of the beginning of the period. Larger movements in price creating a higher price range result in
higher volatility lower price ranges result in
lower
volatility with average true range).
2.1.4 MARKET PERFORMANCE AND
VOLATILITY
There is a strong relationship between volatility
and
market
performance. Volatility
tends to decline as the stock market rises and increase
as the stock market falls. When volatility increase, risk increase and returns decrease. Risk is
represented by
the
dispersion of returns around the means
the
greater the
dispersion of returns
around the means, the larger the drop in the compound
return.
In a 2011 report, Crestmont Research examined the historical relationship
between stock market performance and the volatility of the market. For
this analysis Crestmont used the average range for each day
to measure the volatility of the standard and poor (S&P 500) index. Their
research tells us that higher volatility corresponds to a higher probability of a declining
market. Lower volatility corresponds to a higher probability of a rising market.
For example, as
shown in the average daily range in the S&P 500 index is low (the first quartile 0 to 1%) the odds are high (about 70% monthly and 91%
annually) that investor will enjoy gain of 1.5% monthly and 14.5% annually.
When the average daily range moves up to the fourth quartile (1.9 to 5%), there
is a
probability of a 0.8% loss for the month and a 5.1% loss
for
the year. The effects of volatility and risk are
consistent across
the spectrum.
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