How to Calculate Incremental Volatility

by Walter Johnson

Volatility is a measure of price swings. An easy way to define it is the sum of the deviations from the price average. It works with stocks, mutual funds, hedge funds and bonds. It can describe almost any investment. For more conservative investors, a high rate of deviation from the price norm can be unsettling. Therefore methods have been developed to reduce volatility, one of which is called “incremental volatility,” and was pioneered by a 2009 study by Jodie Ginzberg and Audrey Wang and dealt only with hedge funds.

1. Calculate the volatility in any fund you own. The method is simple: take the daily average price for the fund for a certain amount of time, 20 days or more. Then add up all these deviations for the time period and square it. Divide this figure by 20, or whatever time period you use, and then take the square root. This will give you an accurate volatility rate of the fund.

2. Decide whether this volatility rate is too high. If high deviations worry you, then begin the process of “incremental volatility change.” The point here is to add more funds that, taken together, lower your portfolio's total average volatility. Now you begin to calculate incremental volatility.

3. Buy more hedge or mutual funds. The Ginzberg and Wang study showed that, when an owner has a single hedge fund that is very volatile, adding more funds decreases volatility. In their work, they showed that adding five more funds to the first volatile one lowered volatility by 1.5, 1.5, 1.8 and 0.6 percent for each added fund. In other words, at least for hedge funds, adding more will lower volatility. This is called an “incremental reduction.” The study dealt only with hedge funds. There is no evidence that this will not work with mutual funds.

4. Calculate the alteration in basic deviation for each new fund you buy. The process is the same as calculating any other volatility measure. Now, you average the daily price for the fund for two or three funds, not just one. Therefore, your 20 days will be the average price of the three funds per day. You are taking the average of the daily average. This is the simple way to calculate incremental volatility.

5. Avoid buying more than 10. The Ginzberg and Wang study showed that the law of diminishing returns begins to function around 10. Once you buy more than 10 funds to lower overall volatility, nothing changes. After 10, adding funds does little or nothing to your portfolio.

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