Different academic disciplines have a habit of calling the same thing by different names. In finance, the spreadoutness of an investment’s returns over a specific period of time is called its volatility. Investors often use this as a measure of how risky it is to own a particular stock. This is nothing more than the standard deviation that we’ve already learned about. It makes sense that investors would worry about the standard deviation of stock prices; the size of the average move from the mean tells the investor how much the stock is likely to go up or down (most of the time). Volatility is usually computed on the returns of a particular investment. Returns are the money gained expressed as a percentage. Since the base number is a percentage, volatility is expressed as a percentage as well.
It is important to note that the returns of investments are not normally distributed. In the coming sections, we will learn a lot of useful rules about what percentage of observations fall within a certain distance of the mean, and we will measure those distances in standard deviations. These rules only work when the measurements we are dealing with are normally distributed. Stock market returns have “fat tails,” and don’t always perform as our rules suggest. Many investors have been ruined because they didn’t take those “fat tails” into account when determining how much risk they were taking on.
Key Terms
Measures of Variability, Spread, Dispersion, Heterogeneous, Homogenous, Range, Interquartile Range, Standard Deviation, Variance
Last Modified: 06/03/2021