Volatility is the term that measures the variability of the trajectories or fluctuations of prices, of the profitability of a financial asset, of interest rates and, in general, of any financial asset on the market.
If the price of an asset moves a lot and very fast, that price is said to be very volatile. As we will see below, in many areas the standard deviation is used as a measure of volatility.
Therefore, it must be taken into account that volatility only measures the past behavior of an asset or economic variable. It should not be confused with future risk, although prices that have been volatile in the past typically remain volatile in the future. Even so, analysts assure that the only way to feel the possible future risks of the asset is through the examination of it.
Specifically, volatility is a concept that is used more and more in the financial world and in the world of investment funds. The volatility registers shows how the profitability of a given fund has deviated from its historical average, therefore the standard deviation is used as an indicator of volatility.
Thus, a high standard deviation means that the returns (generally monthly data are used) of the fund have experienced strong variations, while a low standard deviation indicates that those returns have been much more stable over time. Logically, the higher the standard deviation, the greater the potential loss for the participant and, consequently, the greater his risk. Let's see a simple practical example of the returns of two investment funds of the famous manager Bestinver:
It can then be said by comparing the historical returns of both investment funds, that the Bestinfond fund has a lower volatility than that of Bestinver Internacional. This means that the behavior of the returns by Bestinfond has fluctuated around the historical average, that is, the average values have moved less than the other fund that has a higher volatility.
But volatility, by itself, does not offer much information to the participant. What does it mean, for example, for a fund to have 20% annual volatility? Hence the importance of comparing the volatility of the fund with the mean of its category and the means of the categories between them. Furthermore, as we mentioned at the beginning, volatility measures past behavior, so in the future it does not have to behave in the same way.
In equity funds, it is important to carry out a sector and regional analysis to know what the exposure to each sector or region is. In fixed income funds, it will be necessary to know the duration of the bonds to determine the risk of rising interest rates. In mixed funds, it is necessary to see the weighting to fixed income and equities to know the sensitivity to each of the points discussed.
It is essential to know the risk factors of each fund, both through volatility and by doing a portfolio analysis.
In this case, the most common way to measure market volatility is through the VIX index. It is a global indicator that, although it is calculated with the price of financial options on the S&P 500 United States index, has worldwide influence. This index tells us if it is high that there is fear and pessimism in the market, at which point it takes a negative relationship with the S&P 500 (negative correlation). Therefore, we can conclude that it tends to have a negative correlation with the American stock market as it is the volatility of the Chicago options market.