Variability, by definition, is the extent to which data points in a statistical distribution or data set diverge—vary—from the average value. Moreover, it’s about how much these data points differ from each other. In financial terms, this concept is primarily pertinent to the variability of investment returns. Grasping the variability of investment returns is just as critical for professional investors as understanding the value of the returns themselves. Investors often equate high variability of returns with a higher degree of investment risk.
Key Insights
- Defining Variability: It refers to the divergence of data from its mean value, commonly used in statistical and financial sectors.
- Application in Finance: Variability often applies to investment returns; investors typically prefer high returns with lower variability.
- Standardization: It’s a tool to standardize returns on an investment, providing a benchmark for further analysis.
Mastering Variability
Professional investors regard the risk of an asset class as directly proportional to the variability of its returns. Consequently, investors demand higher returns from assets with more extreme variability of returns, such as stocks or commodities, compared to assets with lower variability like Treasury bills.
This expectation difference is also known as the risk premium. The risk premium signifies the extra amount required to incentivize investors to invest in higher-risk assets. If an asset exhibits greater variability in returns but doesn’t demonstrate a higher rate of return, it becomes less attractive to investors.
In statistics, variability refers to the differences noted among data points in a data set, as related to each other or the mean. This can be depicted through range, variance, or standard deviation. Finance applies these concepts specifically to price data and the returns arising from price changes.
- Range: This is the difference between the largest and smallest values assigned to a studied variable. In financial data, it often refers to the highest and lowest price values for a specific period.
- Standard Deviation: Represents the spread among price points within a time frame.
- Variance: The square of the standard deviation based on data points within the timeframe.
Special Considerations for Investors
One measure of reward-to-variability is the Sharpe ratio, which calculates the excess return or risk premium per unit of risk for an asset. Essentially, the Sharpe ratio provides a metric to assess the compensation an investor receives relative to the overall risk assumed by holding the investment. The excess return is based on the performance beyond risk-free investments. All factors being equal, an asset with a higher Sharpe ratio delivers more return for the same level of risk.
Related Terms: risk premium, standard deviation, variance, Sharpe ratio, asset class.
