Let's use a simple example that will resonate with clients to help them understand the volatility risk score.
In a soccer match, the "volatility" can be compared to the unpredictability of the game. This unpredictability can come from sudden changes in the game, like a key player getting injured or the opposing team changing their tactics suddenly.
The Volatility Score is like a rating of how well your soccer team can handle these unpredictable changes.
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Imagine your team has players that are really good at playing a slow, defensive game, but struggle when the game becomes fast-paced and attacking (these are the 'short vol' players).
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On the other hand, you have players who thrive in a fast, attacking game, but are less effective when the game is slow and defensive (these are the 'long vol' players).
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Ideally, you want a balance of these two types of players on your team, so you can handle whatever style of game you encounter.
If your team is made up mostly of one type of player, you may struggle when the game style changes suddenly. This is like a portfolio with a high Volatility Score (closer to 10) - it's more at risk when the market suddenly changes.
However, if your team has a good balance of both types of players, it's more likely to handle any game style well. This is like a portfolio with a low Volatility Score (closer to 1), indicating that it can weather different market conditions better.
In summary, just as a balanced soccer team is more likely to succeed in different game conditions, a portfolio with a lower Volatility Score is better equipped to handle sudden market changes.
How is it different from standard deviation?
Standard Deviation is like looking at how consistent a player's performance is from game to game. Let's say we have a player who scores 3 goals in one game, 0 in the next, then 2, then 1, then 4. The standard deviation would measure how much this player's scoring deviates from their average performance. A high standard deviation means the player's performance is unpredictable - they might score a lot of goals one game and none the next. A low standard deviation means they're pretty consistent - they score a similar number of goals each game.
The Volatility Risk Score, on the other hand, is like looking at how the team performs under different conditions - say, during a regular game day versus during a high-stakes tournament. Some teams might play pretty consistently no matter the situation, but others might be really affected by the pressure and change their playing style significantly during important games. This score would take into account how volatile or changeable the team's performance is under different conditions. A high score means the team's performance changes a lot depending on the situation (they are more volatile), while a low score means they're pretty steady, no matter what's going on.
So while standard deviation looks at the consistency of a single player's performance, the Volatility Risk Score looks at how the whole team's performance changes under different conditions.