What is volatility?
Volatility can also be seen as an (one) indicator of risk and the extent and speed of exchange rate movements. This is all true, it is good to know what the potential is and what its limitations are.
What is the risk of investing?
It would be easy to point out that risk is the degree of exchange rate risk, but it is not.
If you look at the two yield curves, or rather the yield line here, you can see that neither is riskier than the other, as in both cases you will know exactly how much money you have and how much you will have.
The risk is that you, as an investor, suffer a loss.
And this is difficult to accomplish in the picture above. Your money will only accumulate faster at the right side with the greater slope. In order for an investment to be risky, it is necessary to be “able” to make a loss, that is, to have a realistic probability of doing so.
The root causes of loss
There is a lasting and unwanted change in the life of the company.
The company whose securities you hold has undergone some unwanted change that has caused its price to fall permanently. Nor is it ruled out that so much so that the company itself ceases to exist.
This can happen for several reasons, such as:
- due to technological change, your product has become redundant
- an external regulation made it impossible to operate
- some mistake was made by the management of the company
You are scared of the fall in the exchange rate
Due to a temporary price drop, you are selling at a lower price than you bought.
While there is no guarantee that waiting will help you either avoid a loss or make a profit, it is definitely a good idea when it comes to the second case.
Why is volatility suitable for measuring risk?
The price of a given stock includes a lot. Everything that investors have at that moment. It shows not only the information but also its lack. When the volatility of a given stock is high, it shows a great deal of uncertainty on the part of investors. Therefore, it also poses a high risk.
How to measure volatility?
You measure the exchange rate movement compared to itself
Average deviation from the exchange rate average ( σ )
The standard deviation is suitable for this, which shows the deviation from the average level of the exchange rate. The sign is sigma.
The smaller the deviation of the exchange rate of a given period from the average exchange rate of the period, the lower the volatility will be.
Example of standard deviation calculation
This is how the exemplary exchange rates develop
| Period | Exchange rate | Deviation from average |
|---|---|---|
| 1 | 100 | -4,5 |
| 2 | 130 | 25,5 |
| 3 | 75 | -29,5 |
| 4 | 42 | -62,5 |
| 5 | 120 | 15,5 |
| 6 | 160 | 55,5 |
If you calculate the average, you will get that the average price will be 104.5. Subtracting this price from all the numbers gives you the deviation from the average. (Substituted into the formula used to calculate the standard deviation, you get that the deviation will be 38.23.)
Variance ( σ2 )
To filter out ups and downs and see a trend instead, they even use the sigma square you might encounter as variance. (In the example above, the variance will be 1461.25.)
You can use either standard deviation or variance to choose the same type of asset with the best return and lower volatility for you.
You compare the degree of movement to the market
Not only is exchange rate movement natural for investments, but it is actually an expected phenomenon at some level (it would be very difficult to achieve exchange rate gains at prices that are completely motionless).
Then you look at how much and in what direction the value of your investment will change if the market moves 1%. For stocks, beta shows it, and for bonds, duration does you a good service.
What mistakes can you run into if you only have volatility as a measure of risk?
You realize your loss out of sheer fear.
There is typically a basic instinct in people that is commonly referred to as the fear of being left out. This turns on when exchange rates rise dynamically, as many investors fear being left out of seemingly easily achievable earnings.
Because of this, many of the more experienced are getting on top of the exchange rate rise.
When the exchange rate falls for any reason, they are frightened and, in fear of further loss, prefer to sell this investment. And that’s exactly what they’re going to lose. If they had waited for the rebound even with not looking at it every day, they would have been left with their money.
In the case of short-term investments, volatility is definitely an expression of risk, after all, even intraday shifts can have a serious effect on your return. In the long run, however, just paying attention to this is the point that it encourages you to have losses when sold at a low point.
You focus too much on the price of that stock.
It is a fact that the price of a stock with higher volatility falls more easily than it is that people tend to sell at a low point for fear of losing, so more investors may have a higher loss with stocks with high volatility.
Apart from this, a distinction must still be made between the share price and the share value.
Take, for example, a company that is completely stable anyway, there is a market demand for its product. The shares of this company should be worth, say, 10.000 forints. If the exchange rate suddenly drops to HUF 2.000, it is far from true that your risk is higher, after all, the company has not shrunk to one-fifth. His machines and tools have survived, moreover, it has not lost his market. That is, if you buy a stock at such a time, you get the same, only at a significant discount. This will make you risk even less money.
Avoid volatility
The third mistake is to try at all costs to invest your money in assets that are said to be safe and have low exchange rate movements. Yet volatility is not always bad.
Let us return to the definition of risk for the duration of a sentence. This is nothing more than the probability that the investor will incur a loss.
If you look at the two curves, you can see that while dark blue has far more volatility than light blue, light blue is more guaranteed to produce a loss with less volatility.
Volatility does not give a picture of the future.
The fourth, which you should pay attention to when calculating volatility for a given period, is therefore obligatory to look backwards.
If you’ve already invested in anything other than a bank deposit, you may have heard that past returns are no guarantee for the future.
To be able to calculate volatility, you need already fixed exchange rates. This, in turn, shows what effects the company has had in the past. However, as an investor, you will be much less interested in than what to expect in the future.
If anything has happened in the life of the company that affects its life, through this its level of risk, it will only appear in the exchange rate, but only later.
How to handle highly volatile assets?
This is obviously in order to get a favorable result for you as well.
From what you have seen so far, although volatility is not equal to risk, it still expresses it quite well. That’s why, in order to get good results, you need to do the same as with high-risk assets.
That is, diversify. Share this risk.
Diversification between assets
For different devices, higher performance in one direction compensates for lower performance in the other direction. This has been discussed in more detail in the article on cost average.
Diversification over time
Then the results of one period balance the setbacks of other periods. The basic condition for this is to think long-term. The market is going up, so if you wait for the rebound, you won’t be at a loss.
You can even use them in combination to have an investment with the right level of risk for you, but still with a good return.
Questions:
- How do you use the opportunity of volatility to your advantage?
- What do you consider to be your weaknesses other than those listed?
- For your own portfolio, how do you find the balance between risk and return?
If you have any questions, please contact us so we can help you.