Volatility Versus Direction
Volatility does not measure the direction of price changes, merely their dispersion. This is because when calculating standard deviation (or variance), all differences are squared, so that negative and positive differences are combined into one quantity. Two instruments with different volatilities may have the same expected return, but the instrument with higher volatility will have larger swings in values over a given period of time.
For example, a lower volatility stock may have an expected (average) return of 7%, with annual volatility of 5%. This would indicate returns from approximately negative 3% to positive 17% most of the time (19 times out of 20, or 95% via a two standard deviation rule). A higher volatility stock, with the same expected return of 7% but with annual volatility of 20%, would indicate returns from approximately negative 33% to positive 47% most of the time (19 times out of 20, or 95%). These estimates assume a normal distribution; in reality stocks are found to be leptokurtotic.
Read more about this topic: Volatility (finance)
Famous quotes containing the word direction:
“The young ... look into visages dull-eyed, long-toothed, wattle-necked, and chop-fallen, something they have never been and which they cannot imagine ever being.... If it occurs to a young person, looking at us, that this is the direction in which he himself travels, how can he forgive, let alone bear the sight of, us, who constantly bring him the bad news of our own faces, bitter signposts pointing to his own destination?”
—Jessamyn West (1902–1984)