Investing in High Volatility Stocks
Volatility and risk are two words that investors use interchangeably, although technically, they are two different concepts. Risk refers to the event that an investment decision will not generate the expected outcome. Instead, volatility represents a situation in which you are not aware of the possible outcome and, therefore, you cannot exercise any control over it. Although different in their meaning, the risk of an individual stock relates to its volatility. Thus, high volatility stocks are considered riskier because you cannot accurately estimate the extent of the upside or downside of their fluctuation.
How to Estimate Risk Using Volatility
To estimate the volatility of a stock, we are using the variance (σ2) and the standard deviation (σ). The use of the standard deviation (σ), which is the square root of the variance, is widely preferred because as a percentage it facilitates comparisons. High volatility exists when stock prices fluctuate higher than expected due to factors that do not pertain to stock valuation but rather to investor psychology.
You own 500 shares of company A and 500 shares of company B. Based on the returns per quarter, the average return of stock A is 4.23% and the average return of stock B is 8.20%.
To estimate the variance, we use the following formula:
The variance of stock A is:
σ2Α = (2.45%-4.23%)2 +(4.38%-4.23%)2 + (3.96%-4.23%)2 + (6.12%-4.23%)2 = 0.068%
The variance of stock Β is:
σ2Β = (7.56%-8.20%)2 +(9.14%-8.20%)2 + (8.63%-8.20%)2 + (5.25%-8.20%)2 = 0.089%
Thus, the standard deviation (σ) of stock A is the square root of 0.068% = 2.61% and the standard deviation (σ) of stock B is the square root of 0.020% = 1.41%
To determine the risk of each stock, we need to calculate the coefficient of variance (CV), using the formula:
CV = standard deviation (σ) / average stock returns
The CV of stock A is:
CVA = σΑ / average stock returns = 2.61% / 4.23% = 61.85%
The CV of stock B is:
CVB = σB / average stock returns = 1.41% / 8.20% = 17.23%
Notice that the stock with the higher volatility, stock A, has the lowest average stock returns, which indicates that as an investor, you need to investigate more than the returns of a stock to determine its growth potential.
Systemic vs Unsystematic Risk
The factors that cause the stock prices to fluctuate can be external, such as interest rates, inflation, unemployment, and exchange rates, i.e. factors pertaining to the macroeconomic environment, or internal, such as the company’s bargaining power, competition within the industry, research and development of new products and services, i.e. factors pertaining to the environment of the firm.
External factors cannot be controlled by the company, and they are sources of systemic risk. Therefore, as systemic risk we define the percentage of volatility of stock returns that is due to economic, political and social factors. Instead, internal factors can be controlled by the company, and they are sources of unsystematic risk. Therefore, as unsystematic risk we define the percentage of total risk that is unique to each company or industry.
Beta and Stock Volatility
The beta coefficient indicates the relationship between the volatility of a stock and the volatility of the market, which has a beta equal to 1.0. The beta of average-risk securities equals 1.0 and their prices fluctuate on average as much as the market. The beta of low-risk securities is lower than 1.0 and their prices fluctuate on average by a lesser amount than the market. This makes low-beta securities less volatile than the market. In contrast, high-risk securities with a beta greater than 1.0 are more volatile than the market because their prices fluctuate sharply.
Although high-beta securities fluctuate more than the market, they can offer you a higher return potential. If you rely your investment decision on beta analysis, you need to understand the inherent relationship between security beta and portfolio beta. Thereby, if a security with a beta greater than 1.0 is added to a portfolio with a beta that equals 1.0, then the portfolio beta (bp) will increase. Instead, if a security with a beta lower than 1.0 is added to a portfolio with a beta that equals 1.0, then the portfolio beta (bp) will decline.
Investing in High Volatility Stocks
You hold a $200,000 portfolio, consisting of 4 high-beta stocks as follows:
The portfolio beta (Pb) is the weighted average of all the individual securities’ betas. In this case:
bp = (35,800/200,000) x 1.32 + (52,100/200,000) x 1.38 + (48,700/200,000) x 1.44 + (63,400/200,000) x 1.77 = 1.51
Since 1.51 > 1.0, this portfolio is riskier than the market and more likely to experience sharp price fluctuations.
After 2 months, you sell stock B and replace with stock E, which has a beta equal to 1.8.
The beta of your portfolio becomes:
bp = (35,800/200,000) x 1.32 + (52,100/200,000) x 1.8 + (48,700/200,000) x 1.44 + (63,400/200,000) x 1.77 = 1.62
Note that the relationship between the security beta and the portfolio beta is sustained as by adding a high-beta stock the portfolio risk increased.
The Bottom Line
By and large, beta reflects the correlation between a security and the market by offering a clear, quantifiable measure. In some cases, high volatility stocks with low market correlation have modest betas, while stocks that are perfectly correlated with the market have a lower volatility. Have in mind that investing in high volatility stocks does not guarantee an upside market rally, while it bears a certainty of a huge downside. Thereby, make sure to evaluate the broader economic and financial environment before selecting a high volatility stock.