Improving Volatility Labels for Better Investment Decisions

Upon feedback from internal and external stakeholders, the smallcase team has made a few changes to the calculation with respect to the volatility label of a smallcase which we wanted to highlight in this edition of musings.

First things first, what do I mean by the volatility label? The volatility label you see on the header of every smallcase is essentially a risk indicator. The label indicates whether the smallcase is – High/Medium/Low Volatility in order to help investors make an informed investment decision. For instance, the image below shows that the Brand Value smallcase is categorized as a medium volatile smallcase, indicating that an investor with a moderate risk appetite can consider investing in the smallcase.

Secondly, how does this volatility get calculated? Allow me to talk to you about the way it used to get calculated earlier. Post that, we shall take a look at the new changes made to the calculations.

Before:

The Volatility Ratio (VR) was calculated by comparing the average 1-year standard deviation of the smallcase’s daily return since launch with that of Nifty 100’s. 

The volatility was then mapped such that for smallcases with VR >= 1.3, the High Volatility label was displayed; for VR >= 0.8, but less than 1.3, the Medium Volatility label was served; and finally, for VR < 0.8, the smallcase was marked as Low Volatility.

What’s the issue with the before calculation?

Currently, the algorithm was designed such that if a smallcase exhibited low volatility in the initial years of the launch, but had been experiencing very high volatility recently, the volatility labels will continue to show low volatility for a long time, as no additional weight was given to the recent volatility patterns. Technically speaking, the algorithm gave equal weightage to all the data points while calculating the average annual standard deviation for the smallcase and the Nifty 100 index, before calculating the volatility ratio.

Here’s how the smallcase team is updating the logic for the calculation of volatility.

After:

Now the Volatility Ratio is calculated by giving more weightage to the latest 1-year daily return (for both the smallcase and Nifty 100) in order to capture the recent behaviour of the smallcase. 

This is expected to make the volatility label more responsive to recent market trends and solve any previous concerns. The volatility ratio obtained will be mapped to labels by using the below table:

_{Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Registration granted by SEBI, membership of a SEBI recognized supervisory body (if any) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.}

_{The content in these posts/articles is for informational and educational purposes only and should not be construed as professional financial advice and nor to be construed as an offer to buy /sell or the solicitation of an offer to buy/sell any security or financial products.Users must make their own investment decisions based on their specific investment objective and financial position and using such independent advisors as they believe necessary.}

_{Windmill Capital TeamWindmill Capital Private Limited is a SEBI registered research analyst (Regn. No. INH200007645) based in Bengaluru at No 51 Le Parc Richmonde, Richmond Road, Shanthala Nagar, Bangalore, Karnataka – 560025 creating Thematic & Quantamental curated stock/ETF portfolios. Data analysis is the heart and soul behind our portfolio construction & with 50+ offerings, we have something for everyone. CIN of the company is U74999KA2020PTC132398. For more information and disclosures, visit our disclosures page here.}