Variability vs. Volatility in Finance

Instructor: David Bartosiak

Dave draws off his years of experience as a Financial Advisor and Analyst to teach others all about finance and the investing world.

This lesson teaches the concepts of variability and volatility. These concepts are then detailed as they specifically pertain to the world of finance and investment returns.

The Brothers of Risk Analysis

Variability and volatility walk hand-in-hand. Both help investors understand the risk associated with a particular investment. While they are often used to describe how risky an asset is, the two have separate definitions. They aren't the twins of risk, but rather the brothers of risk.

Variability

Variability, as a statistical concept, describes how much a population changes. In finance, variability measures how spread out an asset's returns are likely to be. One key aspect of variability is that it's not defined over a set period of time. In this way, variability is more of a description of an asset's personality. How likely is an asset's future return to deviate from the historical return of that asset?


Large variability of water out of a hose
hose


Let's use as an example a garden house nozzle that has several different settings. The nozzle can be set to a jet which shoots out a tight rope of water or to shower which shoots out a broad, gentle stream of water. Changing the setting on this nozzle is essentially changing the variance. The jet, with its tight rope of water, has low variability. Each molecule of water stays close to the average location of the water coming out. On the flipside, the shower spreads the water out over a wider area. This wider area has a much higher variability as each molecule of water is more spread out than the water molecules are in the jet setting.

Coming back to the finance world, assets with high variability will have returns that are spread all over the place. Assets with low variability will have returns that are much closer to each other. Investments that move slow-and-steady have a tendency to have low variance. Since there is limited upside in these slow-and-steady investments, these are for investors that refuse to take on much risk.

Think of the savings account. The variability in returns on savings accounts is very small year-over-year, a fraction of a percentage point here or there. Investments like stocks have much larger variability. Some years the market has huge returns (over 20%) and in other years it can drop 20% or more. The sporadic returns each year can vary dramatically, just like the water from the shower setting on a water nozzle sends water all over the place.

The Other Brother

Variability's brother is volatility. Volatility measures how much returns deviate from average over a set period of time. Assets which have high levels of variance are probably going to experience volatility over most periods of time.

Going back to the hose and nozzle, if the variance is the different settings on the nozzle, volatility describes how the water hits the ground. If the water is being sprayed out for a minute, the spread of the splash pattern is a good measure of volatility over that minute.

In mathematical finance terms, variability describes the variance of the total population, while volatility describes the variance of a specific subset. Variability is more of a vague characteristic, volatility can be clearly defined. Most of the time volatility is defined as the standard deviation of returns. The standard deviation measures how much a data set varies from the average of the set.

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