Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Which aspect of investment volatility is emphasized when historical data uses smoothed values?

1. Volatility is overstated

2. Volatility is understated

3. Volatility becomes unpredictable

4. Volatility is not affected

The correct answer is: Volatility is understated

When historical data uses smoothed values, volatility is understated. Smoothing techniques, such as moving averages or other forms of data averaging, are used to reduce the noise from day-to-day price fluctuations in an investment's returns. This approach can mask the true level of volatility experienced over shorter time frames, leading to a perception that the price movements are less risky than they actually are. By averaging over time, extreme high and low returns are dampened, resulting in a smoother trend that does not capture the full range of fluctuations. Consequently, investors may not fully appreciate the underlying risk associated with the asset, leading to an understatement of its volatility. This reinforces the importance of using raw data when assessing the risk profile of investments, as relying solely on smoothed data can result in ill-informed investment decisions that overlook significant market movements.