When speaking about investments, volatility measures the expected level of dispersion or scattering in a range of investment outcomes or returns. Typically, standard deviation is one of the more popular arithmetical ways of measuring investment volatility. This is a percentage measure of how far investment returns may differ from the expected return (i.e. the average or mean return) usually over a specific time frame. It is important because it measures these differences both on the upside and on the downside, or more simply, positive and negative returns.
So, an asset or fund which demonstrates large variations in return would illustrate high volatility and therefore could be described as having high investment risk. On the other hand, a fund or asset with a more steady and predictable level of return illustrating lower volatility could be described as having lower investment risk. Historically, the volatility of equities on average has been 15-20% per annum. By comparison, the average volatility of bonds has been 5-10% per annum. Therefore, the higher the volatility percentage figure, the wider the range of potential returns both negative and positive and therefore the higher the risk.
Following on from the great global financial crisis, the European Securities and Markets Authority (ESMA) produced guidelines on how risk can be described to potential investors in key fund information literature. The guidelines provide 7 different risk categories 1-7, ranging from lowest (1) to highest risk (7). The 7 different categories are based on the 5 year annualised volatility of a fund. These guidelines are intended as an aid to investors to help identify the correct risk category for their investment and also will make it easier to compare funds using fund volatility and the resultant returns.
For example two different funds with the same volatility may produce different returns. Generally and naturally, the fund producing the greater return for the same level of risk taken will be the more attractive to a potential investor. Of course there are other considerations to be taken into account by an investor and his or her adviser, but this is an important one.