Using Volatility to Inform Your Stock-Picking Decisions

We talk about volatility in a general sense all of the time. It is not unusual to say, “oh this stock is moving a lot today – it is looking pretty volatile.” Other times, we tie the concept of volatility to our perception of the “riskiness” of a certain security or use it to gauge the uncertainty that we may have about the future changes in the stock’s value. But, truthfully, when it comes down it, many investors do not really understand what volatility is or how it can be used to help them improve their stock-picking decisions.

In investing, volatility is discussed frequently in several ways. The first type of volatility –historical volatility – is the “basic” kind that we typically associate with individual stocks. Historical volatility is defined as the “a statistical measure of the dispersion of past returns for a given security.” In regular terms, this means that historical volatility is a measure of how much the price of a stock rose and fell over a period of time. It is typically measured using the standard deviation or variance between returns from that security over long periods of time.

But, how does this help investors pick their stocks? Well, using this measure of a stock’s past fluctuations, we can get a sense of how volatile that stock typically is and we can also tell how that stock is currently performing relative to a sort of “benchmark” period of time. For example, if a stock seems to be fluctuating much more than its historical volatility, we would believe this stock to be “less stable” than usual and might start asking what kind of investor sentiment could be causing such fluctuations. Effectively, the information we take from a stock’s volatility can help us to uncover other information about a stock that may help us better understand its price.

Further, we can use volatility to compare different stocks. Basically, the higher a stock’s volatility, the larger the range between its price movements within the time frame that we are looking at. This means that the price of this security can change more dramatically over a short period of time – whether it be moving up or down in price. A lower volatility indicates more “steady” or “stable” changes in value over a period of time. Then, since an investor can prefer either higher volatility stocks or lower volatility stocks depending on his or her strategy and risk outlook, these comparisons may help investors choose between different securities.

Another way that we commonly discuss volatility in investing is with volatility indexes. Just as we can calculate an individual stock’s volatility, we can also calculate a relative volatility for an index, such as the S&P 500. Many investors will use these indexes to gauge the performance of the markets. Further, investors will often associate a big increase in volatility with poorer performance in the market – because more people may be inclined to sell their shares in times of weaker markets, making share prices more volatile. Understanding the implications of this large-scale volatility, then, can help investors try and decide when the markets are stable or when might be a good time to invest.

Finally, investors will sometimes also look at the relationship between individual stocks’ volatilities and the volatilities of the indexes. This can help investors get a better understanding of how a certain security has performed relative to the markets in the past. From there, an investor can look at the current price of the security and determine whether the security is operating within its “normal” range relative to the market.

Ultimately, any of these factors can help an investor get at least a better sense of how a security has typically performed in the past. From there, an investor can use this information to better inform his or her investment decisions in the future!