What is financial volatility and how to avoid it?

What is financial volatility and how to avoid it?

Volatility is the main measure of risk and there are several ways to minimize its impact on portfolios

What is financial volatility and how to avoid it?

Risk in finance can be very intuitively defined as the probability that investors are wrong. When they buy shares, what they are looking for is an expected return assuming a certain risk in return.

Thus, the risk of an investment is nothing more than the volatility of returns or the dispersion of past returns with respect to its average. In other words, the risk depends on how strong the ups and downs of profitability are. And that is volatility.

Statistically, it is calculated with the variance, but since this is a measure without a metric, analysts often use the standard deviation of daily returns. That is, the risk of stocks, volatility, is measured as the deviation from past returns.

The concept of volatility is often used to refer to the abrupt movements of a certain index, for example, the IBEX 35. The best-known indicator on a global scale is the VIX, which measures the volatility of the S & P500 and which shot up as soon as the coronavirus pandemic explodes. But the concept of volatility is much broader.

Volatility as a measure of dispersion of returns

The teachers Francisco Lubián and Pablo Estévez offer an example to understand the concept in their book “Stock market, markets and investment techniques”.

Let’s suppose an investor who wants to decide between Telefónica and BBVA, and has the daily prices for one year. With these prices you can calculate the daily returns, and with these, the expected return, which is nothing more than the average of the returns or your mathematical expectation (the mean).

If in the case of Telefónica, for example, the expected return were 0.11% and in BBVA 0.06%, the calculation of the standard deviation of the securities (which can be done with Excel) would give Telefónica 1 62% and 1.94% in BBVA.

As investors prefer to have a higher return and lower risk, it is clear that in this example Telefónica would be more attractive than BBVA, since the bank promises a lower return (0.06%) with higher risk (1.94%).

Volatility measures the probability that an investment will lose value

This is academic definition of financial volatility and how to calculate it. In practice, investors do not usually pay much attention to the concept of standard deviation as a measure of volatility, although it is usually expressed in the commercial file of practically all investment funds.

How do you explain Angel Faustino, financial analyst and book author “Invest your savings and multiply your money”The important thing is to be clear about the concept, to understand that risk, measured by volatility, is “the probability that an investment will lose value.”

By its very definition, and because it is associated with risk, many investors will want to avoid volatility, or at least minimize it. It is reasonable to want to do so, but volatility itself, as a concept, is neither good nor bad.

Investors’ risk tolerance defines assumed volatility levels

There will be investors with more tolerance for risk who are willing to assume greater volatility in their portfolios, in exchange for obtaining better returns.

“A portfolio manager, a retail investor, will adjust this parameter based on their investor profile or the investment mandate that a fund or diversified portfolio has,” comment analysts from XTB.

What’s more, the most active investors, such as traders, usually look for operations with volatility to take advantage of specific market movements.

On the contrary, “long-term passive investors will prefer less volatility since in this way it is easier to calculate what the expected profitability is”, explain the analysts of IG.

Systematic risk cannot be avoided

Once investors are clear about what volatility implies, they will have to define their profile to determine the level of risk they want to take, in order to try to minimize it.

There will always be a market or systematic risk that can be eliminated and that is given by the simple fact of investing.

It is usually quantified through the risk-free asset of the market in which it is invested, the German 10-year bond in Europe or its counterpart the USA, for example.

How to reduce volatility

On the contrary, the risk of the asset in which it is invested can be minimized or even reduced to zero “if the investor or the manager diversifies the portfolio until they achieve it,” they recall in XTB.

Specifically, it is about taking advantage of diversification through a varied portfolio of assets, such as fixed income, equities, liquidity, different geographical areas or different maturities.

For example, they explain in IG, the famous investor Ray Dalio It makes a portfolio that it calls permanent made up of 40% long-term bonds, 30% stocks, 15% medium-term bonds, 7.5% gold and 7.5% other raw materials.

In this way, your portfolio is hedged when the equity market falls and you take advantage of rises in the stock market when there is optimism.