Computing Volatility and Identifying its Limitations

Alexandre Landi

IBM, Skema Business School

January 28, 2025

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Introduction to Volatility

Volatility
Measures variation in investment returns
Key indicator of risk
High volatility = Higher risk

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Steps to Calculate Volatility

Overview
1 Gather historical return data
2 Calculate the mean return
3 Determine deviations from the mean
4 Square the deviations
5 Calculate the variance
6 Find the standard deviation (volatility)

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Step 1: Gather Historical Return Data

Return Data
Daily, weekly, or monthly returns
Example: Monthly returns = 5%, -3%, 4%

First, gather your historical return data. This data can be daily, weekly, or monthly returns, depending on your analysis needs.

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Step 2: Calculate the Mean Return

Mean Return
Return1 + Return2 + · · · + Returnn
Mean Return =
n
Example:
0.05 + (−0.03) + 0.04
Mean Return = = 0.02
3

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Step 3: Calculate Deviations

Deviations from Mean

Deviation = Returni − Mean Return

Example:
Month 1: 0.05 - 0.02 = 0.03
Month 2: -0.03 - 0.02 = -0.05
Month 3: 0.04 - 0.02 = 0.02

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Step 4: Square the Deviations

Squared Deviations

Squared Deviation = (Returni − Mean Return)2

Example:
Month 1: 0.032 = 0.0009
Month 2: (-0.05)2 = 0.0025
Month 3: 0.022 = 0.0004

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Step 5: Calculate the Variance

Variance
(Returni − Mean Return)2
P
Variance =
n−1
Example:
0.0009 + 0.0025 + 0.0004
Variance = = 0.0019
2

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Step 6: Calculate the Volatility

Volatility (Standard Deviation)

√
Volatility = Variance

Example: √
Volatility = 0.0019 ≈ 0.0436 or 4.36%

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Conclusion

Volatility Calculation Summary

Gather data, calculate mean, deviations, squared deviations, variance,
and finally volatility
Example showed monthly volatility as 4.36%

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Next Steps

Upcoming Topics
How to annualize volatility
Comparing investments across different time frames

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Introduction to Annualizing Volatility

Annualizing Volatility
Scaling short-term volatility to annual terms
Essential for comparing different timeframes
Useful for investments with different reporting intervals

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Why Annualize Volatility?

Purpose
Standardizing risk comparisons
Making meaningful comparisons

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Annualizing Volatility Formula

Formula
√
Annualized Volatility = Volatility × Number of Periods in a Year

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Example Calculation

Monthly to Annual Volatility

Monthly volatility = 2%
Number of periods in a year = 12
√
Annualized Volatility = 2% × 12 ≈ 6.93%

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Benefits of Annualizing Volatility

Investor Insights
Evaluate risk on a common basis
Better-informed investment decisions

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Introduction to Limitations

Annualized Volatility Limitations

No information about asymmetry and extremes in return distribution
May mislead toward assuming a normal distribution
Treats all volatility equally, both upside and downside
Sensitive to the selected time period

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Normal Distribution Assumption

Normal Distribution Assumption

Simplifies calculation and interpretation
Real-world returns often exhibit skewness and kurtosis
Can underestimate extreme returns

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Equal Treatment of Volatility

Upward vs. Downward Volatility

Treats all volatility the same
Risk-averse investors focus on downside risk

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Time Period Sensitivity

Time Period Sensitivity

Short-term vs. long-term volatility
High market stress periods

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Numerical Example

Example Calculation
January: 4%
February: 7%
March: 5%
4% + 7% + 5%
Average Monthly Volatility = = 5.33%
3
√
Annualized Volatility = 5.33% × 12 ≈ 18.46%

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Summary

Key Points
Annualized volatility is useful but has limitations
Best used with other metrics

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Summary

In some next episode, we will discuss which other metrics can be used in
conjunction with volatility for a more accurate assessment of risk.

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