Why You Must Understand How Volatility Works

For the investor, this poses a risk as he or she might not be able to determine whether the price change will be favorable or not when it is time to cash in on his or her investment gains.

When we hear about volatility in any investment venture, we often think or risk. We thinking of unpredictability of our investments and we think of fluctuations that could crash our investment value or significantly increase it - depending on the time factor involved.

By definition, volatility is simply a measure of dispersion that is measured by calculating the standard deviation of specific returns over a given period of time. It can actually either be measured with standard deviation or just by determining the variance between returns from that same security or market index.

It represents the rate at which the price of a security, which in this case are stocks, increases or decreases. In other words, if the price of one security is ₦50 today and in a week’s time it becomes ₦85, then this price movement is the volatility of the investment.

If the price movements are stable with only little dispersions, say ₦50 to ₦53, then it is said that the security has low volatility. However, if the price of the security you want to invest in cost only ₦50 yesterday and is now ₦115, hypothetically of course, it means the security is highly volatile as the movements are simply too erratic.

For the investor, this poses a risk as he or she might not be able to determine whether the price change will be favourable or not when it is time to cash in on his or her investment gains.

This is why investors are encouraged to hold on for the long term when investing because these volatile prices eventually even out over the long term. What this means is that volatility only exists in the short term.

Volatility doesn’t always mean risk

The real problem with volatility is not that prices are moving erratically; it is that prices are increasing and decreasing erratically. If, in a hypothetical situation, you purchase a security at ₦50 and all through the period it keeps increasing, then you wouldn’t consider to the stock to be risky.

It could be ₦60 today, then ₦75 tomorrow; as long as it keeps rising, an investor will not be so worried about the riskiness of it. It is important to note this because often times, we mistake volatility to mean risk and this is not accurate.

You can take advantage of it

The way to make gains is to buy at a low rate and then watch it grow. Since volatility, if left for the long term eventually evens out, you can take advantage of the low rates to buy.

The conscious investor can leverage low rates by purchasing stocks in a good company with good records when the price is low, and then wait for the long term growth.

The risk is if the investor is trading for short term gains. If you buy and you want to sell the moment a high rate is recorded, then you are trading. You are at a risk of panicking at price movements and you might end up withdrawing your funds when the investment hasn’t attained its full potential yet.

Written by Lawretta Egba.