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volatility

How much and how often an investment's value goes up and down.

Volatility is how much and how often an investment's value swings up and down. For long-term investors it is usually measured as the standard deviation of yearly returns: a single number that says how far a typical year lands from the average year.

A rough rule helps to read it. About two years in three fall within one standard deviation of the average, so the average minus one standard deviation is a fair picture of an ordinary bad year. Rarer years go much further, which is why volatility should always be read next to the worst year and the maximum drawdown.

Volatility is the price of higher expected returns, not a sign that something is broken. Stock funds swing a lot and grow more over decades; short bond funds barely move and grow little. The useful question is not "how do I avoid volatility?" but "how much swing can this money and I live with, for how long?"

Example

Zapas's synthetic Tessaro World index returns 10.3% a year on average over 40 years with a standard deviation of 14.7%. So a typical bad year is about 10.3 − 14.7 = −4.4%, and a typical good year about +25%; 28 of the 40 years land between the two.

The tails are wider: the worst year is −30% (year 22), the best +34%, and 9 years are negative. Tessaro Short Bonds, by contrast, average 4.6% with a standard deviation of only 1.0% and no losing year at all.

Common mistakes

  • Treating the average minus one standard deviation as the worst case; the real worst year was far lower.
  • Judging risk by volatility alone without the maximum drawdown and the time to recover.
  • Reading monthly swings as yearly ones: a monthly figure looks small but compounds into large yearly moves.
  • Concluding that a low-volatility fund is risk-free; inflation and rates can still erode it.

Learn it in the course