Volatility

Volatility is the size and frequency of an asset's price fluctuations over a period, most often measured as the annualized standard deviation of its returns.

How volatility is measured

FINRA's guide to stocks describes the size and frequency of a stock's price fluctuations as its volatility and calls it an important measure of investment risk, both market-wide and for an individual stock. The most common quantitative version is historical volatility: the standard deviation of periodic returns, usually daily, scaled to an annual figure by multiplying by the square root of the number of trading periods in a year (about 252 for daily data). An annualized volatility of 20% means that, if returns were roughly normally distributed, about two-thirds of years would see a return within 20 percentage points of the average. Volatility is direction-neutral, so a stock that rises sharply is as volatile as one that falls sharply. FINRA also notes that growth stocks generally tend to be more volatile than value stocks, and smaller companies' shares more volatile than large firms'.

Hypothetical example: a stock's daily returns have a standard deviation of 1.5%, so annualized volatility is 1.5% × √252 ≈ 23.8%; 0.8% daily deviation gives about 12.7%. See beta and implied volatility.

Why volatility matters for returns and risk

Volatility drives the range of outcomes an investor can expect over any holding period and therefore how large a loss might have to be endured before a thesis plays out. It also reduces compound growth for a given average return: a portfolio that gains 30% then loses 30% ends at 91% of its start, while one that gains 10% then loses 10% ends at 99%, a gap known as volatility drag. High volatility raises the cost of options because larger swings make both calls and puts more likely to finish in the money, and it lowers the position size an investor can hold. Volatility tends to cluster, rising sharply during market declines and fading during advances. The SEC's asset allocation guidance notes that the volatility of stocks makes them risky in the short term even though long-horizon investors have generally been rewarded.

Hypothetical example: Portfolio A returns +25% then −15% and ends at 1.25 × 0.85 = 106.3% of its start; Portfolio B returns +5% twice and ends at 110.3%, despite the same 5% average. See the drawdown recovery calculator.