Realized Volatility

Realized volatility is a measure of how much an asset's price has actually moved in the past. Think of it as the historical, factual record of a stock's price turbulence over a specific period, like the last month or year. It’s not a forecast or a guess about the future; it’s a look in the rearview mirror to see how bumpy the ride has been. Whereas other metrics try to predict the future, realized volatility simply states what happened. It is typically calculated as the standard deviation of an asset's price returns, giving investors a standardized number to quantify past price swings. A high realized volatility means the price has been on a rollercoaster, while a low number indicates a period of relative calm. This retrospective view is crucial for understanding an asset's character and for stress-testing investment strategies against historical turmoil.

At its heart, realized volatility is a history lesson. It tells you the degree to which a stock's price fluctuated around its average. This historical fact is incredibly useful for several reasons:

• Understanding Character: It helps you understand the personality of a stock. Is it a calm, steady blue-chip, or a wild, unpredictable tech startup? The realized volatility gives you a number to back up that feeling.
• Risk Assessment: While value investing separates price fluctuation from true risk (the permanent loss of capital), knowing a stock's historical volatility can help you prepare mentally for its potential price swings.
• Strategy Testing: Investors can look at past periods of high realized volatility to see how their portfolio would have performed, helping them build more resilient strategies for the future.

It's called “realized” because it's based on price movements that have already occurred and been realized by the market.

It's easy to mix up realized volatility with its forward-looking cousin, implied volatility. The difference is simple but profound.

Implied volatility is the market's prediction of how volatile an asset will be in the future. It’s derived from the prices of options contracts on that asset. When investors are fearful and expect big price swings, they bid up the price of options, which in turn pushes up implied volatility. It’s the market’s collective, but often flawed, guess about what's coming next. It’s the weather forecast.

Realized volatility, on the other hand, is what actually happened. It’s the historical data showing how much the price did move. It’s the actual weather report from yesterday, complete with rainfall totals and wind speeds. By comparing the forecast (implied volatility) with the reality (realized volatility), savvy investors can spot opportunities. For example, if implied volatility is consistently higher than what later becomes realized volatility, it suggests that market fear is often exaggerated and options may be systematically overpriced.

You don't need to be a mathematician to grasp the concept, but it helps to know what's under the hood. Calculating realized volatility is generally a four-step process:

1. Step 1: Gather the Data. Collect the historical prices of a stock for a specific period (e.g., the daily closing price for the last 30 days).
2. Step 2: Calculate Returns. Work out the day-to-day percentage change for each day in your dataset. This gives you a series of daily returns.
3. Step 3: Measure the Dispersion. Calculate the standard deviation of those daily returns. This number tells you, on average, how much the returns deviated from their average. This is the core volatility figure.
4. Step 4: Annualize It. To compare volatility across different time frames, the number is usually annualized. This is done by multiplying the daily volatility by the square root of the number of trading days in a year (typically 252). This simply converts the daily figure into a more universal yearly one.

For a disciplined value investor, volatility isn't something to fear; it's something to understand and even embrace.

The key philosophy of value investing teaches that price is not the same as value. The risk an investor should fear is paying too much for a business and suffering a permanent loss of capital, not the temporary ups and downs of its stock price. A high realized volatility simply means the price is bouncing around a lot. For a great business, these bounces are often disconnected from its long-term intrinsic value, creating noise that can be ignored or exploited.

Benjamin Graham's famous allegory of Mr. Market is the perfect lens through which to view volatility. Mr. Market is your manic-depressive business partner who, every day, offers to either buy your shares or sell you his. When realized volatility is high, it means Mr. Market is having extreme mood swings. On some days, he is euphoric and offers you shares at absurdly high prices. On others, he is terrified and offers to sell you his stake in a wonderful business for pennies on the dollar. The value investor simply ignores his euphoria and takes advantage of his panic. High volatility is the sound of opportunity knocking.

High realized volatility is often the very thing that creates a margin of safety. When a bout of market panic causes a stock's price to plummet far below its underlying business value, a massive margin of safety opens up. The greater the (temporary) price drop, the wider the protective buffer for the investor who buys at that point. In this way, a volatile market is a value investor's best friend, serving up wonderful companies at beautifully discounted prices.