Volatility – one of the major components of risk – can be thought of as the cost of expecting an excess return over cash from the market in the long run.

There is more than one type of volatility and understanding each and how they interact can help investors understand what is going on in the market and how the market might react to future unknown shocks or events.

From my previous columns, readers might now better understand how to construct a portfolio. In this current series, the focus is on managing expectations, entering and exiting the market, and sector rotation or rebalancing a portfolio. My first column on this topic sets the scene.

What is volatility?

A basic tenet of finance is that day-to-day movements in a stock price are largely unpredictable. This concept, and a little statistical theory, helps us to translate day-to-day variations in price into what variation might be expected over the course of a year – the so-called annualised volatility.

By construction, volatility cannot be negative but it can get very big as during the global financial crisis (GFC) and other times. Many experts believe that volatility comes in clusters or short bursts before it settles back to some average value – the so-called mean-reversion property. I, and others, also believe that from time to time, the mean level shifts to a new level for an extended period. Being able to distinguish between a break in the mean and a cluster that will dissipate back to the old mean is central to the way I construct equity portfolios and asset allocations.

A stock price (or index) cannot fall by more than 100%, but it can rise by many multiples, so analysts transform the data before calculating volatility. In this transformed world, returns are symmetric; positive shocks of one magnitude are as likely as negative shocks of the same magnitude. Moreover, it is reasonable to think of annualised (transformed) returns, which are the sum of the daily returns, as being bell-shaped or normally distributed, even though day-to-day returns tend to be small with occasional big positive or big negative shocks.

Annualised volatility

Annualised volatility for the ASX200 or the S&P 500 has averaged about 12% for most of the time that these series have been in existence, but there was a mean shift higher during the GFC and one lower after the GFC.

I show my daily calculations in the chart from the ASX200 since 2000. The solid black line is the mean level (actually the median so that 50% of daily estimates are higher and 50% lower) that shifted down in 2003-2005 then back to the same 12% level until mid 2007. The GFC then took over and the recent data suggests that we are now back to the 12% mean as in pre-GFC times. The dotted lines are a simple extrapolation of the GFC level and a ‘normal’ level to better judge where we are up to.

For me, the disturbances in the second half of 2011 were a big cluster ready to return to the normal level. That is one reason why I did not panic last year! Indeed, I see the post-GFC period as starting in January 2010 and there have since been two big clusters, each largely due to the European debt crisis.

If we expect that volatility will be 12% for the next 12 months you can see why it is impossible to predict the market with any degree of accuracy. Even if we ‘knew’ the underlying trend, there is a one-third chance that our prediction for the market will be outside the range of our forecast plus or minus 12%, and one chance in 20 of being outside of our forecast plus or minus 24%.

The bottom line

These calculations come from the normal distribution and our transformed returns. For readers with no statistical background, it does not matter. The important point is the average return on the ASX200 is about 5% so the volatility swamps any forecast.

However, by understanding the concept of volatility – not its calculation – an investor can better navigate his or her way through the noise that bombards the market, but more of that in my next column.

Chart: Daily estimates of annualised volatility of the ASX200

Ron Bewley, Executive Director, Woodhall Investment Research.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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