Back

Measuring risk

Lesson in Course: Portfolio management (advanced, 5min)

I know some assets are riskier than others but how can I quantify that risk?

Eureka!

What it's about: Volatility is the standard deviation of an asset's daily return.

Why it's important: Volatility helps us gauge the risk of an asset.

Key takeaway: Assets with higher volatilities are riskier. They can have a chance to earn us more money or cause us to lose more money.

Most people have grown up learning that risk is the likelihood of a negative outcome. For some, it's something that we feel like we need to minimize at a times. However, within the investing world, our understanding of risk is challenged since required returns are not possible without risk. Instead, risk can be explained as outcomes that aren’t planned or expected. The occurrence of such an event will result in an increase or decrease in the value of the asset (stock, bond, ETF, or any investment). 

The common view of risk is negative

Assets whose prices fluctuate more dramatically are considered riskier since unexpected events have a greater impact on the price. How do we know if we are taking too much or too little risk?

Bring in the statistics

The price of an asset is quantifiable and can be tracked regardless of the currency (dollars, pesos, euros, etc.). By following the price movements, we can see the fluctuations over time and start telling a story with the daily return.

What is  Daily return?

The percent change in an asset's price each day.

We can visualize the daily return on a chart. Let's take a look at an example of $AAPL.

Apple stock daily returns
*based on historical daily adjusted closing price sourced from Yahoo Finance

This graph shows the daily return of a share of Apple stock over a 5 year period from 4/2/2015 to 4/1/2020. We can see that for most days, the price could change by ±5% except on a few rare occasions.

It's hard to build context by just looking at one asset. Let's compare the price movement of a whole basket of bonds by looking at the daily return of $IEF

IEF ETF daily returns
*based on historical daily adjusted closing price sourced from Yahoo Finance

This graph shows the daily return of $IEF, an ETF that tracks the investment results of an index composed of U.S. Treasury bonds with maturities between seven and ten years, over a 5 year period from 4/2/2015 to 4/1/2015. We can see that on any given day, the price could change by less than ±1% except on a few rare occasions where it changed by more than that.  

The fluctuation in daily returns we have noticed can be annualized into a new statistic to allow us to better compare the expected risks of different assets. The statistic is called the standard deviation or volatility.

What is Volatility?

The standard deviation or annual amount of variation in the daily returns of an asset.

A higher volatility means that the daily returns are more spread out and further from the average daily return; whereas, lower volatility means the daily returns are closer together and more in line with the average daily return. The volatility tells us a lot about an asset's risk—more volatility means more risk!

Comparing risk

To put things together and make volatility applicable, let's revisit our examples from above and compare the risk of Apple to the risk of bonds. On any given day, the daily return of APPL typically lies between ±5%; however, the daily return of IEF is usually between ±1%. When we annualize these changes by calculating the standard deviation, we get to a volatility of about 34.0% for APPL and 6.8% for IEF. 

Volatility helps us directly compare risk

This means that $AAPL exhibits 5x more volatility and is therefore considered much riskier than $IEF.  All of this math just proves what we may have already been told, that stocks are riskier than bonds.

 

Actionable ideas

Looking at how the price of an asset fluctuates over time will help you get a sense of how risky the asset is; however, taking it one step further and finding the standard deviation allows you to compare the level of risk between asset classes and the risk of assets in the same class. 

This can also help you decide how much risk you are comfortable with and which investments are appropriate for a portfolio. For example, a standard deviation of 15% might be too much for some but not others.

Glossary

What is  Daily return?

The percent change in an asset's price each day.

What is Volatility?

The standard deviation or annual amount of variation in the daily returns of an asset.