We Don't Quite Know What We are Talking About When We Talk About Volatility

Abstract

Finance professionals, who are regularly exposed to notions of volatility, seem to confuse mean absolute deviation with standard deviation, causing an underestimation of 25% with theoretical Gaussian variables. In some fat tailed markets the underestimation can be up to 90%. The mental substitution of the two measures is consequential for decision making and the perception of market variability.

Keywords: finance, volatility, risk, intuition, statistics, metrics

JEL Classification: D8, D9, E2, G2, N2