As cited above, volatility is the tendency of a security’s market value to fluctuate sharply up or down in the short term. For traders who want to sell off their portfolios at a moment’s notice, volatility and risk are roughly equivalent. But for value investors, who don’t have the urge to liquidate their portfolios any time soon, volatility has limitations as a measure of risk. In the long term, I consider volatility less significant than the values
of the businesses in your portfolio and the prices you paid for those businesses. Despite my reservations about the usefulness of volatility as a risk measure, I think it merits addressing in this chapter for the following reasons:
- MPT is based on the notion of redefining risk as share price fluctuation, or price volatility. But the value investor would find this definition unacceptable.
- Many investors are volatility-averse and cannot tolerate significant short-term price fluctuations in their portfolios. In the academic community, volatility is the only quantifiable measure of risk and is extensively cited in studies of risk analysis.
- Empirical studies also may use beta as a yardstick for risk. Beta measures a portfolio’s relative volatility against overall market movement rather than against its own historical returns.
Understanding terms such as standard deviation and beta can help investors put them in the proper context when evaluating investment opportunities and monitoring their portfolios. Let’s look in greater detail at the concept of beta.