Volatility

Volatility says how much the value of an investment jumps up and down. Not where it is heading: only how calm or how wild the journey is.

It is the most common way risk is measured in practice. It is not the same thing, though: volatility is only one of its forms.

How it is measured

Formally it is the standard deviation, but you do not need to be able to calculate it: it is enough to understand what it says: by how much, on average, the value departs from its own average.

In the example above it works out at roughly 1.4 for investment A and a round 10 for B. A sevenfold difference: with an almost identical ending.

The number on its own is meaningless. It only makes sense in comparison: a fund with a volatility of 18% swings far more than one at 6%.

Why it matters

It decides whether you can cope with it. On paper it makes no difference whether you get from 100 to 104 calmly or wildly. In reality many people sell during a fall from 120 to 90 and lock the loss in permanently. The best investment is the one you can hold through a bad year.

It decides when you need the money. If you are taking it out in a year, volatility is dangerous: you may hit exactly the bottom. Over a thirty-year horizon it is almost irrelevant.

What to watch out for

Volatility is not direction. It measures the size of the swings, not whether you are going up or down. An investment can rise volatilely or calmly and fall the same way.

Low volatility does not mean safety. Cash in an account has almost no volatility and yet, thanks to inflation, it reliably loses value. Calm and safe are not the same thing.

How to work with it

You cannot remove volatility, but you can get around it: with a longer horizon, with diversification and with regular investing, under which the swings stop being a threat.