What does volatility mean in mutual funds?

We often hear the word ‘volatility in our day-to-day lives. What does volatility mean? A constant change or a rapid change, and can also mean unpredictability.

Well, we live in a VUCA world (Volatility, Uncertainty, Complexity, and Ambiguity) where Volatility is a part and parcel of our life. We try to reduce financial uncertainty by constantly saving in our piggy banks (aka our investment portfolio).

We also minimize the uncertainty of life using life insurance products.

Funds and securities are also volatile in this VUCA world. However, we can measure the volatility and make informed choices about our investments.

When we go to some of the websites to make our choice for investing in one of the funds, we often come across indecipherable Greek alphabets such as alpha, beta, etc.

This article is to decode the jargon around volatility, and we assure you that the next time you visit a website or read a report on a fund, it will surely make more sense.

What is volatility in mutual funds?

It means a simple up-and-down, market movement in the value (prices or Net asset value). 

Consider the two cases as shown in the following figures. If the expected price of the stock based on the analysis of historical data is Rs 58.

In Case A, in a short span of time, as an investor or a market participant, I see that the stock has sudden upward movements ranging to Rs 80 and also has a downward movement reaching Rs 40.

Hence, the stock is deviating from the expected price (or the mean price) – this case is considered to be highly volatile or highly unpredictable.

In Case B, we observe that the price is stable or is hovering around the expected price. This stock or fund is considered to be less volatile.

Higher volatility indicates unpredictability – and is perceived as a risk. As an investor, I hence command a higher return as a “price” for my sleepless nights.

If I am willing to take a risk, I invest in Case A, where I could be earning a profit of Rs 22 (higher than Case B) or losing Rs 18 (based on the example) – a double-edged sword indeed.

Volatility is hence a measure that one must consider before investing. As investors, each of us has a different risk appetite. Some of us can sleep even when our portfolio suffers a downward swing of 15%, whereas some of us have nail-biting moments when our portfolio sinks by a mere value of 5%.

Determining your risk aversion becomes a paramount factor in building a tailored portfolio – It is up to you to determine if you want to jump onto the roller-coaster or to take on an easy slide.

How to measure volatility in mutual funds?

Going back to 10th-grade Mathematics – Standard Deviation

The standard deviation essentially indicates the fall and rise of the returns of a fund or the prices of a stock/security. Does it indicate the variation from the mean return? higher the variation, the higher the standard deviation implying higher volatility.

Consider Case B or a fund with a constant return of 9% over a 3-year horizon. Here, the standard deviation is said to be zero (as the mean is 9% and the return every year is 9%) and the fund is less volatile.

However, consider Case B or a fund with returns of 9%, -18%, and 15% in each of the 3 years considered. The mean return of the fund is 6% (average of the returns), and the standard return would be a very high value (here, 17.58%) as the returns of the fund vary from the mean.

However, volatility is one of the indicators of risk, and should not be the only variable that is considered by the investor. Stable past performance does not indicate the same for the future, but it could serve as a good way to project the future.

Hence, as an investor what should you be looking at when you are choosing a fund? Try to minimize risk (volatility) and maximize returns – look for funds that give you similar returns and compare the standard deviations. Add the one with a lower standard deviation into the portfolio.

The Greek letter – Beta (β)

This Greek letter compares the returns of the fund with its benchmark. The beta of the market (here, the benchmark) is 1. If the fund has a β>1, say 1.5 then it indicates that the fund is more volatile when compared to its benchmark, and a fund with a β<1, is considered to be lesser volatile than the benchmark. When the β is closer to 1 it indicates that the volatility of the fund is closer to that of its benchmark. 

Example: Consider β =1.5 for a fund. When the market rises by 10%, the fund’s Net Asset Value would rise by 10%* β = 15%. Similarly, if the market falls by 5%, the fund would decline by 5%* β= 7.5%.

Hence, while choosing a fund consider the one which offers maximum returns with a lower β.