What is variability?
Variability, almost by definition, is the extent to which data points in a statistical distribution or data set diverge from the average value and the extent to which these data points differ. In financial terms, this is most often applied to the variability of investment returns. Understanding the variability of investment returns is just as important to professional investors as understanding the returns’ value. When investing, investors equate a high variability of returns with a higher risk.
Understanding Variability
Expert investors believe that an asset class’s risk is closely related to the variable of its returns. Thus, investors seek a higher return on assets with more return variability, like stocks or commodities, than they could on assets with lower return variability, like Treasury notes.
Another name for this discrepancy in expectations is the “risk premium.” The amount needed to persuade investors to invest in higher-risk securities is the risk premium. Investors will be less inclined to put money into an asset if it shows a higher degree of return variability but not a higher rate.
In statistics, variability is the variation that data points within a data collection display about the mean or each other. A data collection’s range, variance, or standard deviation may be used to describe this. These ideas are used in finance, notably about pricing data and the implied returns resulting from price changes.
The difference between the highest and smallest value attributed to the variable under investigation is known as the range. A single integer is used in statistical analysis to indicate the range. In financial data, this range often refers to the most incredible and lowest price value for a particular day or another period. The variance is the square of the standard deviation based on the list of data points from that same period, and the standard deviation is the spread between price points within that period.
Particular Points to Remember: Diverseness in Investing
The Sharpe ratio calculates the extra return or risk premium per unit of risk for an asset and is one way to quantify reward-to-variability. The Sharpe ratio offers a method to evaluate how much compensation an investor gets for the total risk they are taking by keeping that investment. The excess return is the amount of return realized above investments deemed risk-free. For the same level of risk, the asset with the higher Sharpe ratio yields a more significant return.
Conclusion
- In the statistical and financial domains, variability is typically understood as the deviation of data from its mean value.
- In finance, “variability” is often used to describe return variability; investors want assets with lower variability and greater returns.
- Variability is a benchmark for further study used to normalize investment returns.
