Volatility measures how quickly the price of a security fluctuates relative to its returns. It reflects the risk linked to price changes and is quantified by computing the standard deviation of annualized returns during a specified timeframe.
Share prices in a stock market fluctuate constantly, leading to uncertainty and making it difficult for investors to decide which fund to invest in. The main reason behind this is market volatility, a constant and recurring change that causes share prices to rise and fall over time.
As an investor, you need to be aware of how these unpredictable price movements can affect your portfolio so you can make informed decisions.
In this article, we will understand volatility measurements, how they are calculated, and the factors affecting them.
What is volatility in mutual funds?
Volatility in mutual funds refers to how much the fund's value changes over time. It indicates the risk level by calculating the standard deviation of the fund's annual returns.
If the market conditions indicate there is high volatility, it implies the fund's value will fluctuate significantly. However, if the volatility is low, the value of the fund will remain relatively stable. Understanding a mutual fund's volatility is important to help investors gauge the potential risk and return.
Let us look at an example to understand this better. Assume you want to buy a stock, and its price, based on past historical data, indicates Rs. 50.
Now, two scenarios can occur:
Scenario 1: The stock price jumps quickly to Rs. 70 and crashes suddenly to Rs. 30 due to negative market sentiment. This shows that the price of this stock is highly volatile and unpredictable. This would be a case of high volatility.
High volatility is characterised by unpredictability, which makes it risky. Investors would expect a higher return on the stock to compensate for the risk they took.
Scenario 2: In this case, the stock price does not fluctuate considerably and remains close to Rs. 50. This indicates that the stock is stable and predictable and stays true to its historical number. This would be a case of low volatility.
How to measure volatility in mutual funds?
To make informed decisions and gauge the risk-return potential of a mutual fund, it is important to know how to measure volatility in mutual funds. Volatility measurements can be done in two ways:
1. Standard deviation
Standard deviation represents movements, i.e., the rise and fall of the returns of a given mutual fund. The higher the variation, the higher the standard deviation from the mean, leading to higher volatility.
Let us understand this with the help of volatility measurement of standard deviation.
Assume a scenario where fund ‘A’ gives a constant return of 11% over 4 years. Here, there is no significant movement in the returns of the fund. Hence, the standard deviation is considered zero as the return remains the same.
Now, assume fund ‘B’, where the returns vary significantly over the 4 years: 0.34%, -8.11%, 22.46%, and 2.00%. The mean of this return is 4.17%, which is the average of the returns over the 4 years, and the standard deviation in this scenario is 12.97%.
The constant and extreme fluctuation in the above fund B makes it riskier compared to fund A.
2. The Greek letter – Beta (β)
Beta, the Greek letter, is a volatility measurement technique that compares the fund's returns to the benchmark. Let us assume the market beta is one at the moment.
Now, if your fund has a beta greater than one (β>1), say 1.45, it indicates that the fund is more volatile compared to its benchmark.
If the beta of the fund is less than one (β<1), say 0.75, then the fund is less volatile than the benchmark. In a scenario where the beta is close to one, the fund is considered closer to its benchmark number.
Consider β = 1.45 for a fund. If the market rises by 15%, the Net Asset Value (NAV) of the fund would rise by 15% × β = 21.75%. Similarly, if the market were to fall by 7%, the NAV of the fund would decline by 7% × β = 10.15%.
So, as an informed investor, you should always choose a fund that offers the maximum returns with a lower β.
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Types of volatility
Volatility measurements are done by looking at two major types of data points of the financial market: Historical volatility and implied volatility.
1. Historical volatility
Historical volatility looks at past data to analyse and understand the changes in the prices of stocks over a given period of time. It is also referred to as statistical volatility.
Historical volatility data is used by investors and traders to understand and assess what could be the potential future volatility. Based on this information from past market behavioural data, they can make informed decisions.
If the price of a certain stock has seen major fluctuations or upswings or downswings, it is said to have high historical volatility.
2. Implied volatility
Contrary to historical volatility, implied volatility looks at the expectations for the future. It is also known as projected volatility and is calculated from the prices of options. Options are contracts that give you the right to buy or sell an asset at a specific price. This measure helps investors understand the expected fluctuations in an asset's price.
If the prices of the options are higher, it can be considered a future indicator of possible price swings.
However, if the prices of the options are low, it means more stable prices and lower volatility.
Based on these values, investors and traders try to make decisions about the future course of the market movements.
Also read about: What is an Asset Management Company (AMC)?
How to calculate volatility?
To calculate market volatility, we use the standard deviation and variance formulas. By now, we know that volatility represents changes in the share price over time. To calculate it, we take the standard deviation and then multiply it by the square root of the number of years.
The formula for volatility measurement over a specific period is v = σ√T, where
- v represents the volatility over a certain time interval
- σ\sigma is the standard deviation of total returns
- T is the total number of periods within the specified time frame
What are the factors affecting volatility?
Volatility is affected by several factors, which include:
1. Economic scenario
Economic growth indicators like GDP, employment, inflation, budget deficits, central bank rates, etc. also influence market volatility. Any positive or negative developments can lead to great fluctuations in the market as investors reassess their holdings. For example, a high growth rate can inspire confidence and make share prices skyrocket as investors feel that the economy is healthy and heading in a good direction.
2. Geopolitical developments
Any geopolitical instability in a country or region leads to a sudden and extreme increase in market volatility. International clashes, conflicts, trade tensions, or diplomacy crises can create an atmosphere of uncertainty and force investors to readjust their holdings to ensure safety.
3. Sentiments of the market
Investor emotions, often referred to as market sentiment, significantly impact volatility. Emotions like fear, greed, and uncertainty can cause sudden changes in buying and selling behaviour. When sentiment shifts abruptly, such as through a surge of optimism or a rise in fear, it can lead to higher market volatility as traders react to these changing perceptions.
4. Company’s performance
When earning reports of companies are out, they can have a significant impact on market volatility. Revenue reports, any new product launches, innovations, legal battles, or management changes can positively or negatively impact the stock prices of the company, leading to sharp price movements.
Key takeaways
- Volatility reflects the rate at which the price of securities fluctuates, serving as a risk indicator for investors.
- It can be measured via standard deviation (how much fund returns vary) and beta (how a fund compares to the market).
- Historical volatility analyzes past price changes, while implied volatility predicts future price movements based on options.
- Economic conditions, geopolitical events, market sentiment, and company performance all influence volatility.
- Understanding and managing volatility is key to making informed mutual fund investment decisions.
Conclusion
Market volatility is a fundamental part of the broader market dynamics. You cannot time it or eliminate it, as it is unavoidable. Instead of being fearful of it, it is important to understand volatility measurements and make decisions to maximise gains and minimise losses.
By being cognisant of factors that lead to it, such as economic downturns, geopolitics, interest rate cuts, etc., investors can be cautious and safely navigate market highs and lows by implementing tried and tested investment strategies to safeguard their capital.
For those looking to manage volatility effectively, the Bajaj Finserv Mutual Fund Platform offers a range of investment options and tools designed to help you make informed decisions and optimise your portfolio. The Bajaj Finserv Mutual Fund Platform has more than 1,000 mutual fund schemes, allowing for easy mutual fund comparison and selection.
