Historical Volatility

Historical Volatility (also known as 'realized volatility') is a statistical measure that tells you how much an asset's price has bounced around over a specific period in the past. Think of it as a stock's “moodiness score.” A stock with high historical volatility is like a dramatic teenager, with its price swinging wildly up and down. A stock with low historical volatility is more like a stoic grandparent, with a price that remains relatively calm and stable. This measure is calculated using the standard deviation of the stock's price changes over time and is typically expressed as an annualized percentage. For example, a historical volatility of 20% means the stock's price has historically tended to move within a 20% range (up or down) of its average over a year. It’s a purely backward-looking metric; it tells you about the road already traveled, not the road ahead.

You don't need to be a math wizard to grasp the concept, but it's helpful to know what's under the hood. Calculating historical volatility (HV) involves a few simple steps:

1. 1. Gather the Data: First, you collect a series of historical prices for a stock, usually the daily closing prices, over a chosen period (e.g., the last 30, 90, or 252 trading days).
2. 2. Calculate Daily Returns: Next, you figure out the percentage change in price from one day to the next for the entire period. These are the daily “jumps” or “dips.”
3. 3. Find the Standard Deviation: You then calculate the standard deviation of these daily returns. This number quantifies how spread out the daily price changes are from their average. A bigger number means more spread, hence more volatility.
4. 4. Annualize It: Since the calculation is based on daily data, the final step is to scale it up to represent a full year. This is done by multiplying the daily standard deviation by the square root of the number of trading days in a year (usually 252). The formula looks like this: Annualized HV = Daily Standard Deviation x √252.

For a value investing purist, price volatility isn't the same as risk. In fact, it can be your best friend.

The great investor Warren Buffett famously noted that “Volatility is far from synonymous with risk.” True risk, for a value investor, is the chance of a permanent loss of capital, which happens when you buy a poor business or overpay for a good one. Price swings are just noise. High volatility often reflects fear or panic in the market. When Mr. Market has a meltdown and sends a stock's price plummeting, its historical volatility spikes. For the disciplined investor who has analyzed the business and determined its intrinsic value, this panic creates a golden opportunity. The wild price drop can create a significant margin of safety, allowing you to buy a wonderful company at a ridiculously cheap price. In this view, volatility isn't something to be feared; it’s the very thing that serves up bargains on a silver platter.

Relying on historical volatility as your primary measure of risk is like driving while looking only in the rearview mirror. A company with a history of low volatility can suddenly face a catastrophic business challenge (like a new competitor or a product failure), making its stock incredibly risky overnight. Conversely, a company with high historical volatility might be on the cusp of a turnaround, with its future set to become much more stable. The key is to focus on the underlying business fundamentals—its competitive advantages, management quality, debt levels, and earnings power—not just the squiggles on a price chart.

It's crucial not to confuse historical volatility with its forward-looking cousin, implied volatility (IV).

• Historical Volatility (HV): This is the actual volatility the stock exhibited in the past. It’s a historical fact, like looking at last month's weather report.
• Implied Volatility (IV): This is the market's forecast of what volatility will be in the future. It is derived from the prices of stock options. It’s the market’s best guess at the weather for next month.

Comparing the two can be insightful. If a stock's implied volatility is much higher than its historical volatility, it suggests that the market is expecting a storm ahead. For a value investor, this could be a signal of peak fear and, potentially, a great time to be greedy when others are fearful.

Here’s how to put historical volatility to work:

• Know the Personality: Use HV to get a quick sense of a stock's character. Is it a calm, steady compounder or a wild, unpredictable beast?
• Embrace the Swings: Don't automatically shun high-volatility stocks. They are often the hunting ground for the best bargains, as fear drives prices well below intrinsic value.
• Look Forward, Not Back: Always remember that HV is a backward-looking metric. Your investment thesis should be based on the company's future, not its past price patterns.
• One Tool, Not the Whole Box: HV is just one piece of the puzzle. Use it alongside rigorous fundamental analysis to make informed decisions.