Thursday, 11 September 2014

VOLATILITY’S IMPACT ON MARKET RETURNS



 
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.


This research shows that we need to be aware of the volatility in the market if we hope to adjust our portfolio as it changes.

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