When investors talk about risk, they are almost talking about it in terms of volatility. Volatility (in investing) means changes in prices from the average over a period of time. That timeframe is critically important to the investor. If you can consider volatility in terms of decades, there is little volatility in the stock market. You will make money over long periods as long as you stay the course.
If you (like most traders do) consider volatility in terms of one day or five-minute candlesticks on a chart, then you view it very, very differently. The most commonly used measure of risk is the standard deviation (SD) of the investment’s price. SD is a great measure of risk in most markets, but its value is mostly relevant in the short term. In the long-term reality of investors like Mr. Buffett, the best indicator of risk is not making decent inflation-adjusted returns over the life of the investment.
Volatility is perhaps one of the most intriguing and maligned subjects of conversation among investors. From a mathematical perspective, it is easy to grasp. No matter what you are buying or selling, it has an average price. Prices, however, rarely just sit around at that average. Sometimes they are above the average, and sometimes they are below that average. In other words, all securities trade within a range of values every day. If you’ve ever taken a statistics class, you may remember that the size of these deviations from the mean—the spreadoutness—is referred to as variability. In finance, volatility is merely the variability in prices over a specified number of observations.
If you are a trader, volatility is a prerequisite to making money. If stocks gently glide up over a long period of time without any “turbulence,” you can’t get in and out of stocks. In other words, you can’t buy the dips if there are no dips. Most long-term investors would prefer that there not be any dips. They would prefer that gentle glide higher and higher. This rarely happens in the real world. As odd as it sounds, volatility is volatile. By that, I mean that volatility rises and falls just like stock prices.
Some days (or weeks, or years) volatility will be high, and some days it will be low. In most social sciences, variability is a two-way street; we see scores go up and we see scores go down. In the world of finance, we happily ignore volatility to the upside. In fact, when investors are confident, and the market is up, they will regard volatility as low. This is because of something called the VIX, which is the CBOE’s famed volatility index.
The VIX is not an actual computation of volatility. It is really an indication of how much insurance is being purchased by investors against a pending drop in prices in the form of put options. The actual math is quite complicated, but we will just say that if many investors are paying very high prices for puts, it means that they are scared. For this reason, the VIX is known as the fear gauge. When investors are scared, they tend to sell stocks.
Selling stocks causes downward pressure on prices, which can create a sort of self-fulfilling prophecy if enough investors feel the fear at the same time. When the VIX is around a value of 10, the volatility waters are placid, and there is very little fear among investors. It can spike to values above 40 in rapid declines, such as when the Dow drops 1,000 points in a few minutes. Since the VIX only looks at bets against the market, it is a one-way measure of volatility, unlike variances, covariances, and correlations.