Volatility

Another important investment characteristic is volatility, which measures how much and how quickly the value of a security or market sector changes. The more volatile a security, the more its value fluctuates, and the more risky it can be.

For example, smaller, less-established companies' prices tend to rise and fall more frequently and rapidly than well-established, blue chip companies that tend to have the financial resources to weather economic downturns. Similarly, bonds issued by corporations that already have a lot of debt or other financial problems are more volatile than U.S. Treasuries, which are backed by the full faith and credit of the U.S. government.

You can measure volatility by using measurements known as beta and alpha. Beta measures an investment's volatility in relation to the overall market, which is considered to have a beta of 1. For example, if ABC stock has a beta of 1.25, it is considered to be 25% more volatile than the overall market. Theoretically, this means that if the market rises 8%, ABC stock is predicted to rise 10%. However, the reverse is true as well. If the market falls 8%, ABC stock's value is anticipated to fall by 10%.

Alpha measures a company's internal instability and its volatility in relation to other investments in the same industry group. For example, an alpha of 1.25 indicates that a stock is projected to rise 25% in a year when the return on the market and stock's beta are both zero. Generally, a low priced investment in relation to its alpha is considered a good choice because of its undervalued status.

You take greater risk putting your money in volatile investments. While these types of securities have the potential to produce substantial returns, there is an equally good chance that their value could falter. Even the most aggressive investors might choose other asset classes to help balance their portfolios.