Volatility is a measure of how risky an investment actually is. Volatility measures an investment's return over a certain period, but there are many measures that can be used for volatility. The way an analyst measures volatility depends partly on the type of investment being discussed. Volatility on a bond, for example, is a measure of its yield fluctuation over a given period. Volatility of a stock, on the other hand, can measure price or dividends. All measures of volatility, though, attempt to approximate whether an investment is worth the risk to the investor. 

Measuring Volatility

Volatility can be measured through any number of formulas, but they are all based on some standard deviation from a norm. This norm can be the average price, yield or dividend of a comparable security, or an index can be used for the norm. For example, in a volatility formula, using "beta" will attempt to approximate the overall change in a security's returns based on a market indicator's comparable change. Beta describes the answer to the question "If the S&P 500 experiences a 100 percent move in its benchmark factor, how much will the particular security's benchmark factor move?" If the beta is over one, it moves more, meaning it is more volatile. If it moves less than one, its volatility is lower than the S&P 500's over the same period. 

Using Volatility Measurements to Make Investment Decisions

It is important to understand some basic limitations on volatility measurements in order to use the factor correctly when making investment decisions. First, volatility should always be used as a comparable measurement, not on its own. Simply by looking at how much a security's value moved over a short period, you will not know whether the security is a valuable investment. Instead, you must compare this movement to the movement of another, similar security or index. Then, you must compare the prices. If the more volatile security has a higher price, it is not worth the risk. In a more likely scenario, it will have a lower price. In this case, it may be worth taking the additional risk if other factors indicate rewards could be high. In any case, however, even if potential rewards are high, it is important to always keep in mind highly volatile securities are innately riskier than low volatility investments.

When to Purchase Volatile Securities

You should not engage in risky investing 100 percent of the time, but there are some times when it may make sense. For example, investing in volatile options with your retirement fund is ill advised. Here, you are looking for slow, steady growth. However, if you have made a large profit off a real estate sale and come into a large sum of cash, you may consider a risky investment. In this case, you are already investing surplus money you were not expecting to have. Taking on the risk of turning this cash into something much greater may be worth the added volatility of the option you are considering.

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