Measuring Volatility

AN INVESTMENT’S volatility is often assessed using two different yardsticks: standard deviation and beta. Standard deviation looks at how erratically an investment performs compared to its own history. For instance, it might measure how much a mutual fund’s monthly results stray from its average monthly performance over the past five years.

Meanwhile, beta measures how much an investment fluctuates relative to a market index. Suppose the benchmark used is the S&P 500. If an individual stock has a beta of 1, that means it tends to move up and down in tandem with the S&P 500, so a 1% rise or fall by the S&P 500 would also see the stock gain or lose 1%. If its beta is 1.2, it would be more volatile than the S&P 500, while a beta of 0.8 would indicate it’s less volatile. Investors used to seek out high volatility stocks in hopes of earning market-beating returns, but that notion has since been discredited, as we discuss in the financial markets chapter.

You might imagine that a fund with a high standard deviation will also have a high beta, but that isn’t always the case. For instance, a gold fund will tend to have a high standard deviation—make no mistake, these funds can be wild performers—but the beta relative to the S&P 500 can be quite low, because the performance of gold and the S&P 500 aren’t closely correlated.

You can learn the standard deviation and beta for your funds by heading to Morningstar.com. A caveat: Before you read too much into an investment’s beta, check to see which market index it’s getting measured against.

That brings us to a related concept: correlation coefficients, which measure whether two investments perform alike. Correlation coefficients can range from -1 to +1. If the correlation between two investments is +1, they rise and fall in sync. If it’s zero, there’s no correlation, while a -1 correlation coefficient indicates they move in opposite directions.

U.S. large-company shares, U.S. small-company stocks, developed foreign-stock markets and emerging market stocks are all closely correlated with each other, with scores of 0.8 or higher. Real estate investment trusts are somewhat less correlated with U.S. stocks, but the correlation is still pretty high. By contrast, U.S. stocks’ correlation with both gold and bonds tend to be close to zero or even negative, suggesting that adding gold and bonds to a stock portfolio can be effective in reducing short-term volatility.

Keep in mind that the precise value for these various measures isn’t fixed. In other words, volatility and correlations may appear somewhat higher or lower, depending on the period studied.

Next: Volatility Hurts

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