The Concept Of Volatility
While talking about investments, another concept that is important is volatility.
Volatility is the variation of a particular asset’s price over time. It is the movement of an asset’s prices from the mean.
It is measured by standard deviation or variation of the security’s prices from the market index. Some assets are less volatile while others are more. When it comes to the derivatives market, volatility plays a major role.
Volatility and risk are very closely related. Volatile assets are mostly risky, because their price movements are less predictable. We have discussed risk in detail in the next section.
Volatile assets also give you an opportunity to earn more, because prices can move higher up. However, please bear in mind that this means that prices can move down as well, and you may end up losing money.
The share market is a volatile market. Other volatile markets include commodities, forex, derivatives market, etc.
Volatility is affected by a large number of factors such as the economic and political situation of a country, inflation, global market conditions, oil prices, central bank rate decision and others.
The volatility of a portfolio is the measure of how much and how fast the prices of individual assets of a portfolio goes up and down. This is known as Portfolio Volatility.
How does volatility affect your portfolio?
Volatility has a significant impact on your investment decisions. Let us understand this through an example. Suppose you have a balanced portfolio with traditional asset classes such as stocks and bonds and alternative asset classes such as gold, forex (EUR-USD) and cryptocurrencies. Apart from a bond, all the other asset classes are volatile in nature. Now, suppose the value of the EUR-USD currency pair falls suddenly, your portfolio will suffer a setback. You might want to mitigate the risk by investing more in long term bonds, which has low volatility. On the other hand, suppose you have ₹100,000 to invest today, and you cannot understand where to invest. You come to know of significant news about the Bitcoin market. So, you invest the amount in Bitcoins. Due to the high volatility of the cryptocurrency market, the prices of Bitcoins go up significantly over the next few months, and you end up earning sizable returns.
Of course, this is a much simplistic example. The situation in reality may be more complex.
You must have come across the term volatility index or VIX while reading about business news. A volatility index is an index that calculates the degree of fluctuation of an index such as Sensex or Nifty 50. Every major index in the world has a volatility index. For example, the VIX which tracks the movement of the S&P 500 index of India is known as the CBOE Volatility Index and is the most popular VIX in the world. It is more popularly known as “the VIX”. The term VIX was coined by the Chicago Board of Options Exchange in 1993.
The India Volatility Index is circulated by NSE and calculates the degree of fluctuation expected by active traders in Nifty50 over the next 30 days. This index was started in 2008 and its calculation is based on the famous Black and Scholes Model.
Interpreting India VIX
It is easy to be bogged down with terminologies, but understanding India VIX is really easy. Let us suppose that India VIX is 10.5 today. This means for the next 30 days, active investors of Nifty expect to obtain an annualized return of 10.5 from the index.
Effect of Vix on your portfolio
So how is Vix relevant to you?
If the majority of your portfolio consists of equity, it is a good idea to track Vix. If you see Vix be extremely high, be careful. Such optimism may be a bad sign. Moreover, the market changes rapidly, giving little time to investors to react. Hence, keeping an eye on Vix will definitely help you in the long run.