Hedge Fund
Understanding Volatility, A Powerful Asset For Downside Protection
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Although they are often used synonymously; volatility and risk are not the same. Volatility is a measure of how much an asset value moves and is impacted by economic conditions. Volatility plays an especially important role in investing, risk management and asset pricing.
Volatility is often used as a measure of risk and shows the intensity of fluctuation of individual stocks, indices or other underlying instruments around their average value. The higher the volatility, the more the price moves up and down and the riskier but also more promising the investment. Investors use volatility as a proxy for risk, something by which they can identify changing patterns or movements and can therefore use when making investment decisions, particularly where specific risk tolerances are at play.
A period of low volatility does not mean that investing is low risk. In fact, the opposite can be true. At a macro level, one current concern is that investors take excessive risks when volatility has been rather low, because it tends to mean that market movements – upside and downside – are low and therefore the opportunity to make gains has been reduced. This results in higher potential tail risks. Also, over time specific market risk tends to revert to the mean: so, if it goes through a period of low volatility, at some point volatility will increase to compensate for that, and vice versa.