Volatility is an important statistical measurement when analysing the riskiness of a fund as well as an investment portfolio. Volatility neither measures the degree of price fluctuation nor the maximum gain or loss; instead, it is an indicator of the stability of returns. In fact, volatility exists as long as prices go up and down inconsistently for every month.
Statistically, volatility is the standard deviation of the rate of return of an investment, and both monthly and annualised volatilities are popular risk measurements in the market. Monthly return figures over a three-year period are typically used to work out monthly volatility. Annualised volatility is a product of monthly volatility and the square root of 12.
The following example may help further explain how volatility measures can be applied in risk analysis.
Assume that the annualised volatility and return of the Hang Seng Index are 25% and 20%, respectively. We can say that the probability of getting future returns of the Hang Seng Index locates between 5% (20%25%) and 45% (20%+25%) is approximately 70%.
Why is the probability 70%? Normal distribution is the most common type of distribution, and one standard deviation accounts for about 68%, which is approximately 70%.
The following simplified example can help clarify the meaning of volatility (for easy explanation, only five annual figures are used):
Although both funds obtain a 6.6% annualised return, the volatility of Fund A is obviously higher. Under this circumstance, the fund with lower volatility is the best choice. The higher the volatility, however, the higher the return, investors should decide the best choice depending on their risk tolerance level.
Volatility provides an objective measurement when analysing the risk of a fund or an investment portfolio. By comparing the data of investment return, we can find out the risk–return ratio (i.e., the percentage return for each 1% of risk an investor takes), which can help indicate a wise investment decision.
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