I'll warn you that sometimes I may be using a term in a different context than it is taken for general in the financial world. Remember, it is a concept that I am explaining, not a particular term.
With that in mind I'd like to give some examples of the volatility of an investment. A more volatile substance can cause more side effects than a less volatile substance. For example, take a look at water, gasoline, and nitro-glycerine. If you hit a puddle of water with a hammer, you might get wet. With a puddle of gasoline it may cause a spark which would ignite and burn the gasoline. It could explode, but that is less likely. A puddle of nitro-glycerine, when struck, will explode. Water has low volatility, gasoline medium, and nitro-glycerine is highly volatile.
With that in mind, take a look at the volatility of financial instruments. Yes, they don't burn or explode. What they will do is change value on you either for the better: a gain in value or for worse: with lessening of value. A more volatile investment is one that is subject to larger gains and losses in the presence of ordinary activity.
I address the issue of risk only peripherally, since volatility is its own kind of risk.
A reminder before I make some examples; I'm just explaining volatility here, not talking about investment strategies.
Take a look at cash, which has the least volatility of all financial instruments. Whether it is coin or paper in your hand or numbers in a bank account, it has a numeric value which will not change with time. Yes, it may lose value with time, but that is another (XxX url) matter. The cash could be in an interest-bearing account, and its volatility remains unchanged. For example, lets take $5000 and put it in a 5% interest account for a couple of years.
Year Principal Interest Return 1 5000 250 5250 2 5250 262.50 5512.50 3 5512.50 275.62 5788.12 4 5788.12 289.40 6077.52 5 6077.52 303.87 6381.39 1381.39
See how predictably it behaves?! Just like water. Heck, your bank account is even FDIC insured, in case something goes wrong with the bank you will suffer a slight delay, and then your money will be returned to you, with the value on the last days of the banks operation.
A Bond is an instrument which is a bit more volatile than cash. Why is it more volatile?
Say for example the same funds are in a bond returning 8%:
Year Principal Coupon Return 1 5000 400 400 2 5000 400 800 3 5000 400 1200 4 5000 400 1600 5 5000 400 2000 2000
So, it seems regular like the interest bearing account, just different.
$5000 * 0.90 == $4500 - bummer!
At least the coupon interest makes up for this a little bit.
The total return is now $300, for a total return of 6%.
Yes, it is better than the 5% savings, but still not the 16% total you
were expecting.
$5000 * 1.10 == $5500 -- you get 10% on the bond alone,
plus another 16% on the coupons, for a total return of 26%.
The thing to get out of this is that the price, the value of your investment is more volatile than cash. Due to things beyond your control the both the base value and return of your investment can change considerably [again I'm just using the 2 year mark to keep the numbers the same]
Situation Principal Coupon Yield High Rates 4500 800 6 Expected 5000 800 16 Low Rates 5500 800 26 Full Term 5000 2000 40
Of course if you hold the bond to maturity you will get the face value and expected yield. However if you needed to sell after 2 years, your returns are a bit more volatile than cash.
One last reminder about bond volatility. Even if the company dies, all is not lost with a bond. From the remaining assets of the company, the payouts go:
Stocks are the most volatile instrument I'll make an example out of. You get the idea already, I just want to really show you what increased volatility means!
So, say we buy $5000 worth of company ABC's stock. It could be a growth stock, where its value would increase as the company grows. It could be a value stock, where the company issues regular dividends, and the stock price doesn't change much. Or it could be in-between, both appreciation in value, and providing dividend income.
OK, we buy the stock, 50 shares at $100 per share, with an expected 10% rate of appreciation each year, and a expected dividend of $0.50 per share. Again, higher reward for higher risk, that is why the stock give returns; if it was risky and only gave 3% you'd choose the bank account instead ... and no one would invest in companies. The return is specified in the form <total / yearly/> so you can see the returns compared to the fixed-interest rate of return in the previous examples.
Year Value Dividend Return 1 5000 100 12 / 12.0 2 5500 100 25 / 12.5 3 6050 100 39 / 13.0 4 6655 100 54 / 13.5 5 7320.50 100 71 / 14.2 8052.55 500
So, the stock is giving you great returns, with only modest growth per year.... if everything goes according to plan. The thing is, prices change quite a bit in the stock market. For example, stock values in a well known solid company varied from $82/ to $100/ in a two week period -- and dropped as low as $60/ when something bad happened.
Take a look at what happens when something goes well, and the company appreciates in value -- say Apple and the iPod for example. Stock value increases considerably for a bit, so maybe for two years (3, 4) you get a 25% rate of appreciation. After that it stabilizes at 10% again:
Year Value Dividend Return 1 5000 100 12 / 12.0 2 5500 100 25 / 12.5 3 6050 100 57 / 19.0 4 7562.50 100 97 / 24.2 5 9453.13 100 118 / 23.5 10398.44 500
Ultra super excellent! Look at those returns! Notice per-chance, how the yearly rate of return drops when the growth spurt is over, but keeps on increasing while constant growth is occurring. That can be used to help determine the growth trend of a stock :) If it falls more quickly, the stock may still be taking in returns but the rate of growth is shrinking faster.
But the flip side of stock is that it's price can also decrease. Say for example the market as a whole drops, or the sector or industry. Or a frivolous law suit is held against the company after its product has been out for 1 year and its value looses the year after to 50%, and then starts growing at 10% again the next year. To make this example more understandable, I've added the EOY, end-of-year value of the stock to the table.
Year Value Dividend EOY Value Return 1 5000 100 5500 12 / 12.0 2 5500 100 6050 25 / 12.5 3 6050 100 7562.50 57 / 19.0 4 3781.25 100 3781.25 -16.4 / -4.1 5 3781.25 100 4159.38 -6.9 / -1.3 500
Now, just from a one year faux-paux, the return on investment has been dropped to the level of a negative savings account. The money in the stock has lost a considerable amount of its value. If you needed to sell the stock in year 4 you would only receive about $0.75 for each dollar you invested. less than a $1 -- and this is an example of a single-year down-turn, not the more likely 2-3 year downturn and losses before recovery.
I'll warn you -- I had to make this example worse than my first attempt to get negative returns for a while -- initially I had a -40% loss in stock value from year 3-4, and then year 4 having a 10% increase in value during the year. Simulating a single sharp loss then normal rate of return afterwords. Certainly the stock was not glamorous, but it did return to >$1/ after year 4 and showed a slight positive rate of return in year 5.
Before you get happy though, recall that in 2008-2009 the stock market value lost about 50% of its value. In 2000-2001 the stock market lost about 35% of its value, kept on declining for 3 years, and regained its value after 6 years. The 1929-1930 stock market crash was even worse; the stock market lost an amazing 88% of its value, and it didn't recover to the original value for 25 years!
Using a couple of instruments, I've illustrated how volatile those different kinds of investments can be in the market. The general rule is that with higher reward comes higher risk, and even greater volatility.
If you believe in the market theories and can wait for th long term you will most likely recoup your value from declines. If you need your funds short term, you can take a tremendous loss with the more volatile assets.
I mentioned earlier that stock values of a $100/ stock can easily move $10/ (10%) of value in a few days. One week you could have $5000 worth of stock, the next week $4500, and the following week $5500.
Type Gain Loss T Return Y Return Cash 1381 27.6 5.5 Bond 5yr 2000 40 8 Stock Normal 3552 71 14.2 Bond 2yr Call 800 16 8 Bond 2yr LoInt 300 6 3 Bond 2yr HiInt 1300 26 13 Stock +10% 500 10 Stock -10% -500 -10 Stock Super 5398 118 23.5 Stock Poor -1218 -16.4 -4.1
Using the examples, take away the following notes:
After all of that, what is volatility?? You can see why the various asset classes have different inherent volatilities. But, how do you compare instruments within a class?
I would suggest that it is a combination of how much the value of the investment is likely to change, compared to how long it takes for the value to change.Given two identical types of investment, the one that will have larger swings of value in shorter periods of time is the more volatile of the two.
Shorter term instruments are less volatile, since great changes in the market are less likely to occur in a given time. The longer the term of the investment, the more volatile the market could be.
I would also say that larger companies and diversified companies are likely to have lower volatility than smaller firms, or those that are not diversified. One reason is that a larger firm will have more inherent value, larger market cap, etc. Which means when ordinary things go wrong they will not change the value of the company that much. A diversified company will be less likely to be affected by swings of a given sector or industry than a company specializing in that area.
Factors such as the risk of a bond being called are actually known ahead of time and can be planned into the overall investment strategy.
What is the reverse of volatility -- why do you want it? That is simple -- the the possibility of great returns. You can't get 100% returns in two-three years with a savings account, nor even with a bond. With stocks, however it has happened many times with a stock. And of course, companies keep on making new things that people must have!
The day-traders rely upon the short term volatility of the market to buy lo /sell hi stocks and other things to try and make money.