Volatility reflects the daily ups and downs in the value of investments. Much maligned by investors and the media when prices plummet, volatility is welcomed when investment values head upward. Yet, when was the last time you heard anyone use the word volatile to describe prices going up?

How volatility differs from a roller coaster

Volatility is often equated with riding a roller coaster, but there’s one key difference. When your roller coaster ride ends, youre exactly where you started.

Stock values have trended higher over the long term despite steep periodic declines. From a long-term perspective the declines don’t look nearly as steep as they probably felt at the time.

Living with volatility’s downside

Most people can get reasonably comfortable with volatility by using 4 basic investment strategies:

• Focus on the long term
• Invest regularly
• Diversify your investments
• Keep in touch with your financial advisor

Focus on the long term. One key to living with volatility is focusing on long-term results rather than the daily bumps along the way. This can be especially difficult during prolonged market declines fed by daily injections of bad news.

Invest regularly. Also called rupee-cost averaging, an automatic investment program is another strategy for living with volatility’s downside and taking advantage of its upside. You don’t need to worry about the best time to invest when you put away the same amount every month, but like most investing strategies, it doesn’t guarantee a profit or prevent losses and some people find it difficult to continue buying shares through prolonged market slumps.

Diversify your investments. None of the asset categories does well all the time, so it can be a good idea to put your eggs in a variety of baskets. If some of your investments are down, others may be up.

Keep in touch with your financial advisor. Our last strategy for putting volatility in perspective may be the most important. Financial advisors are trained to focus on your financial goals, your time frame and your comfort with volatility.

Why evaluate a fund’s volatility?

Volatility is how risk manifests itself, so all the common risk measurements that you’ll see below actually gauge how volatile an investment has been in the past not how risky it is.

It’s not enough to evaluate a fund based on performance alone. Financial professionals must also look at its risk-adjusted return, especially for clients with time frames of less than 10 years or those who are very uncomfortable with volatility. That’s why advisors also look at common volatility measures such as R-squared, beta Sharpe ratio and standard deviation.

Common measures of volatility

R-squared. It is the statistical measure of how closely the portfolio’s performance correlates with the performance of a benchmark index. R-squared is a proportion that ranges between 0.00 and 1.00. For example, an R-squared of 1.00 indicates perfect correlation to the benchmark index, while an R-squared of 0.00 indicates no correlation. Therefore, a lower R-squared indicates that fund performance is significantly affected by factors other than the market.

Let’s take an example.

• A fund has an R-squared of 1(typically an index fund) with the S&P CNX 500 index. This means that when the index has gone up, so has the fund, and when it has gone down, the fund has too.
• A fund which doesn’t try to track an index, will have an R-squared less than 1. The behavior of this fund will not match the index. All our diversified equity funds have high correlation with their respective benchmark indices, but not perfect correlation. The reason for this is simple-the stocks and their individual weightings in our fund portfolios are not identical to their benchmark indexes.

All our diversified equity funds have high correlation with their respective benchmark indices, but not perfect correlation. The reason for this is simplethe stocks and their individual weightings in our fund portfolios are not identical to their benchmark indexes.

Beta. It is the statistical measure of a portfolio’s sensitivity to market movements. For example, a benchmark index such as the BSE Sensex or S&P CNX 500 has a beta of 1.0. A beta of more or less than 1.0 shows that a fund’s historical returns have fluctuated more or less than the relevant benchmark.

For example, if a fund has a beta of 1.1 and the market index declines 10%, you could expect the security to decline 11%(on average). A fund with a beta less than 1.0 is less volatile than the market, and could be expected to rise and fall at a slower rate.

Typically you need to use beta in conjunction with R-squared for a better understanding of the fund’s risk-adjusted performance. The lower the R-squared (which means less correlation between the fund and the benchmark utilized), the less reliable beta is as a measure of volatility.

Sharpe Ratio. It is the statistical measure of a portfolio’s historic risk-adjusted performance and is calculated by dividing a fund’s excess return (your investment’s annualized return in excess of the risk-free rate of return available-the extra return you receive by assuming some risk) by the standard deviation of those returns. As a measure of reward per unit of total risk, the higher the ratio, the better.

The main drawback of the Sharpe ratio is that it is expressed as a raw number. Consequently, it’s difficult for one to evaluate the Sharpe ratio of an individual fund by itself. We know the higher the Sharpe ratio the better, but given no other information, we don’t know whether a Sharpe ratio of 1.5 is good or bad. Only when you compare one fund’s Sharpe ratio with that of another fund (or group of funds) do you get a feel for its risk-adjusted return relative to other investment options.

Standard deviation. It is a statistical measure of the historic volatility of a portfolio. It measures the dispersion of a fund’s periodic returns (often based on 36 months of monthly returns). The wider the dispersions, the larger the standard deviation and the higher the risk.

For example:

• Fund A posts annual returns of 8%, 10%, and 12%. Over the 3 years, it earns an average annual return of 10%, with a standard deviation of 1.63.
• Fund B returns 1%, 9%, and 20%. It, too, earns an average return of 10%, but its standard deviation is 7.79.
• Thus we know that Fund B has been more volatile than Fund A.

Standard deviation, like the other measures, cannot be used in isolation, one needs to check the standard deviations of other funds to get a better picture of the fund’s relative volatility. A problem with standard deviation is that it rewards consistency above all else and hence, even if a fund loses money but does it so very consistently it can have a very low standard deviation.

Conclusion

All risk measures have limitations. First, they are based on past performance. Second, no single measure paints a complete picture of risk. Investors should also consider qualitative risk factors such as investment style and portfolio concentration.

Keep in mind that investing is not solely about numbers. Nor is it about avoiding risk. These measures are intended to help you understand risk.