Volatility-Why It's Important

Volatility is one of the most potent forces in the global financial system. Based on the movements in an asset’s price, volatility implies the pricing movements of an asset relative to the overall market. In other words, it measures price variation over time. Suppose company ABC is considered to be extremely volatile. This implies that market movements are magnified in the movement of company ABC's stock price. For example, if the stock market increases one percent in a day, ABC's stock might increase two percent in the same day. Similarly, if the stock market decreases one percent in a day, ABC's stock would likely decrease by two percent.

 

Why is this important? For starters, assessing the volatility of an asset's price helps one determine expected gains. An extremely volatile stock can produce big gains when the stock market goes up. And of course, it can produce big losses when the stock market drops. At the same time, volatility tends to be a loose proxy for risk. Thus more volatile assets tend to be riskier.

 

Investors can analyze an investment's price volatility and determine whether it aligns with their risk tolerance. While there are no guaranteed outcomes when using volatility as a predictive tool, the information it provides can be helpful.

 

Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.

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