Definition of Residual Volatility

By: Steve Lander

Residual volatility is an advanced financial modeling metric.

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Residual volatility measures how much an investment's price jumps around relative to its relationship to an index or other benchmark. It is directly tied to beta, which is a measure of whether a given investment's fluctuations are larger or smaller than that of another index. The factor is used in assessing risk levels and returns.

Technical Definition

Residual volatility is a weighted sum of three factors -- 60 percent of it comes from the investment's daily standard deviation in terms of its extra returns over a one-year period; 30 percent comes from its cumulative range, which is a mathematical tool that analyzes investments that have wild price swings; and the remaining 10 percent is based on its volatility over a trailing one-year period.

Understanding Beta

Beta is another measure of volatility. What the beta does is compare an investment's price swings with those of an index. For instance, if a stock is exactly tracking the Standard and Poor's 500 index, it would be said to have a beta of 1.0. If it had higher upward swings in good times and lower downward swings in bad times, its beta would be over 1.0, while an investment that fluctuates less than the index would be said to have a beta less than 1.0.

Beta vs. Residual Volatility

If beta is like a volume control, residual volatility is like changing the station. Instead of measuring how similarly an investment swings with an index, residual volatility measures how much of its price change comes in a way that is different from the index. In other words, it's the change that comes from the stock itself, as opposed to the change that comes because the broader market is dragging it in one direction or another.

What It All Means

The residual volatility metric typically gets used by people operating at a high level in finance -- it's not something you're going to find doing casual research. However, research based on it has identified a useful trend. Investments with high residual volatility tend to do worse than those with low residual volatility. While you may be able to get rewarded financially for choosing a stock that fluctuates more sharply than the market as a whole as measured by a higher beta, one that moves around a lot independently of the market historically has been just as likely to succeed ---- though with increased risk.


About the Author

Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.

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