Volatility: Risk Measure for Stocks or Portfolios?

Imagine you are planning a picnic. Risk, in the world of investing, is a bit like the chance of unexpected weather ruining your outdoor plans. For an individual stock, using standard deviation, often called volatility, as your only risk measure is like only checking the weather forecast for wind speed to decide if you should bring an umbrella.

Standard deviation, or volatility, essentially tells us how much a stock’s price tends to bounce around over time. Think of it as the size of the waves in the stock market ocean. A stock with high volatility means its price can swing wildly, going up and down a lot. A stock with low volatility has a calmer price, moving more gently. In general, people often associate higher volatility with higher risk, and in some ways, this makes intuitive sense. If a stock’s price is jumping all over the place, there’s more uncertainty about where it will be tomorrow, or next month.

However, when we are talking about investing in individual stocks, just looking at volatility is like only worrying about the wind speed at your picnic. You might be very prepared for a windy day, but what if it suddenly starts raining? For an individual stock, volatility captures all sorts of price swings, both the ‘wind’ and the ‘rain’ in our analogy. Some of these price swings are due to things specific to that company. Perhaps the company announced a fantastic new product, and the price jumped up. Or maybe they had some bad news, like a product recall, and the price dropped. These are company-specific events, and the risk associated with them is what we call ‘unsystematic risk’ or ‘diversifiable risk’.

Imagine you only invested in one single tech company. If that company faces a major cyberattack, its stock price could plummet, regardless of how the overall market is doing. This is unsystematic risk at play. But here’s the crucial point: you can reduce or even eliminate this kind of company-specific risk by not putting all your eggs in one basket. If you own a variety of stocks across different industries, from technology to healthcare to energy, the impact of bad news at one company is lessened because you have other investments to cushion the blow. This is the power of diversification.

Now, let’s think about a well-diversified portfolio, our picnic with not just an umbrella, but also rain boots, sunscreen, and maybe even an indoor backup plan. When you diversify, you significantly reduce the impact of those company-specific ‘rainstorms’. What remains is the ‘market weather’, the broader economic conditions that affect almost all companies to some extent. This is called ‘systematic risk’ or ‘non-diversifiable risk’. Think about things like interest rate changes, recessions, or global pandemics. These events impact the entire market, and no amount of diversification can completely eliminate their effect.

For a diversified portfolio, volatility becomes a much more useful measure of risk. This is because, by diversifying, you have largely washed away the unsystematic risks. The volatility you observe in a diversified portfolio is now primarily reflecting the systematic risk, the ‘market weather’. This is the risk that investors are truly concerned about and need to be compensated for.

When investors think about the risk premium they require, they are essentially asking: “What extra return do I need to be convinced to take on risk?” For a diversified investor, the risk they are concerned about, and therefore require a premium for, is primarily systematic risk. Since volatility of a diversified portfolio now largely reflects this systematic risk, it becomes a more relevant measure for determining the appropriate risk premium.

So, going back to our picnic analogy, for an individual stock, volatility is like checking the weather forecast for all possible weather events, both the company-specific ‘showers’ and the market-wide ‘climate change’. It’s a broad measure, including risks you can actually manage away through diversification. However, for a diversified portfolio, volatility is more like checking the overall climate risk for the picnic, focusing on the risks that are harder to avoid, the systematic risks that truly require compensation for taking on. That’s why standard deviation, while imperfect even for diversified portfolios, becomes a more meaningful risk measure in that context, especially when considering the risk premium investors demand.