Let’s start by trying to offer a definition of the concept: volatility measures the intensity of the changes undergone by the value of a security in a given period of time. In other words, volatility indicates the percentage change in the value of a security or portfolio: it is a measure of the intensity of the fluctuation.
From a mathematical point of view, volatility is measured as a percentage and indicates the distance of the price of a security from its average value in a given period. If, for example, we say that a share has had a volatility of 20% over the last year, this means that on average the distance of its value from the average price of the share has been 20 percentage points.
In simpler words, high volatility will correspond to more marked price changes, while low volatility will correspond to a relatively more controlled price trend.
Is volatility a synonym for risk?
One might think that the volatility of a security indicates the level of risk associated with it. This is not incorrect but it is only part of the story. Certainly by owning a more volatile stock you are more exposed to fluctuations in its value. This means that to maintain it over time you will have to be ready to tolerate a more eventful trend. Not everyone is ready to see the value of their portfolio go up and down in the same way: this is why it is important to understand your risk appetite when deciding to invest (find out how to evaluate your risk appetite). If you have a marked aversion to risk it is advisable to opt for less volatile portfolios, even at the cost of sacrificing some returns.
Is less volatility better?
On the other hand, less volatility is not necessarily associated with a better result. Let’s take the example of the performance of these two indices over a period of approximately three years. The red index represents the performance of higher risk corporate bonds while the blue index represents the performance of lower risk corporate bonds.
The trend of the red index is certainly more volatile (as can be seen from the numerous fluctuations) but it is also the one that has generated the most returns in the period of time considered. The second index certainly had less steep swings, but its value remained practically constant.
Are there ways to limit the effects of volatility?
Once again it is important to clarify the objectives with which you invest and above all to select the right time horizons. By adopting a long-term perspective, risk aversion being equal, you will be able to focus on the medium-term trend by giving less weight to daily fluctuations (the secret to investing with serenity). There are speculative strategies, such as market timing (find out what it is), which try to take advantage of the daily fluctuations with continuous trading operations.
If your goal is to increase and protect your savings, it is probably better to opt for another strategy. In this case, the best solution is to create a strategic portfolio that takes advantage of medium-long term macroeconomic trends (find out what asset allocation is).
Another way to limit volatility is to build a well diversified portfolio. Thus the movement of some asset classes will reduce that of others and this will allow your capital to grow in a more balanced way (discover the secrets of diversification).
Ultimately volatility is not a good or bad thing in itself. Fluctuations are part of the investment process and unfortunately there is nothing you can do to eliminate them. What matters is understanding your needs and your goals in order to find the solution that best suits you.
How we build portfolios around volatility
When building portfolios, we have created a method to meet all of our clients’ risk needs. Portfolios are made up of a mix of different asset classes such as stocks and government bonds. Each asset class is made up of different risk and return profiles which can be estimated based on historical data. For example, stocks are generally more volatile than bonds but have historically generated higher returns over the medium and long term. All possible mixes of asset classes make up the entire risk spectrum. We have estimated that through 9 model portfolios we can meet the yield and volatility control needs of the majority of client investors.