Want to know how risky an investment is? You need to look at its volatility

Julie Brownlee, Fsp Invest, 26 Sep. 2014

Tags: volatility, what is volatility, risk, investment risk, standard deviation, investing,

Different investors have different appetites for risk.

For example, one investor may be happy putting some money into trading single stock futures. This carries a lot of risk. Whereas another investor may opt to invest in bonds. This carries a low risk.

So how can you measure investment risk?

It all comes down to the volatility of an investment.

So what exactly is volatility? And how can you use it to make investment decisions?

Let’s take a closer look…

What is volatility?

Volatility is a measure of investment risk.

What it does is show you how much an investment’s annual returns bounce around their long-term average.

You can work this out by calculating the standard deviation of returns.

The more drastic the annual ups and downs of an investment are, the more risky or volatile that investment is.

What investments are volatile?

Looking back, shares and gold are very volatile investments. Cash and bonds, on the other hand, are less volatile investments.

For instance, think about shares. You can invest in a company, then some bad news comes out, either from the company or about the general economy, that hit the shares hard. This can cause its share price to jump about, up and down.

Whereas, if you have cash in a savings account, you know that in two months’ time, you’ll have the same amount in the bank, with perhaps interest added on top of that.

Why understanding volatility can help you make investment decisions

By understanding volatility of different investments, you can use that knowledge to avoid investing in unsuitable vehicles that don’t suit your tolerance for risk.

For instance, if you’re nearing retirement, you probably don’t want to hold a lot of your wealth in shares. That’s because if the stock market crashed, you don’t have long enough to wait until those shares recover.

Yet a younger person can afford to put more money into shares as they have the time to let the stock market recover.

So there you have it. If you want to know how risky an investment is, you need to look at its volatility.

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