What is Variability?
Variability is the extent to which data points in a statistical distribution or data set diverge from the average value as well as the extent to which these data points differ from each other. In financial terms this is most often applied to variability of investment returns. Understanding the variability of investment returns is just as important to professional investors as understanding the value of the returns themselves. Investors equate a high variability of returns to a higher degree of risk when investing.
- Variability refers to the divergence of data from its mean value.
- This concept works the same in the fields of statistics and finance.
- Variability in finance is most commonly applied to variability of returns.
- Investors prefer investments that have higher return with less variability.
Understanding Variability of Returns
Professional investors perceive the risk of an asset class to be directly proportional to the variability of its returns. As a result, investors demand a greater return from assets with higher variability of returns, such as stocks or commodities, than what they might expect from assets with lower variability of returns, such as Treasury bills. This difference in expectation is also know as the risk premium, The risk premium refers to the amount required to motivate investors to place their money in higher-risk assets. If an asset displays a greater variability of returns, but does not show a greater rate of return, investors will not be as likely to invest money in that asset.
Just as in statistical studies, variability refers to the difference being exhibited by data points within a data set, as related to each other or as related to the mean. This can be expressed through the range, variance or standard deviation of a data set. The field of finance uses these concepts as they are specifically applied to price data and the returns that changes in price imply.
The range refers to the difference between the largest and smallest value assigned to the variable being examined. In statistical analysis, the range is represented by a single number. In financial data, this range is most commonly referring to the highest and lowest price value for a given day or other time period. The standard deviation is representative of the spread existing between price points within that time period, and the variance is the square of the standard deviation based on the list of data points in that same time period.
Variability in Investing
Variability is used to standardize the returns obtained on an investment and provides a point of comparison for additional analysis. One measure of reward-to-variability is the Sharpe ratio, which measures the excess return or risk premium per unit of risk for an asset. In essence, the Sharpe ratio provides a metric to compare the amount of compensation an investor receives with regard to the overall risk being assumed by holding said investment. The excess return is based on the amount of return experienced beyond investments that are considered free of risk. All else being equal, the asset with the higher Sharpe ratio delivers more return for the same amount of risk.