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Understanding Stock Volatility

May 11, 2020 · 7 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

Understanding Stock Volatility

“Stocks have taken a nosedive!”

“Stocks are soaring to new heights, breaking all previous records!”

“Stocks have flatlined because of [insert news story of the day]!”

There seems to be no way to have a conversation about the stock market without discussing the wild swings in stock prices. This is called stock market volatility. The volatile nature of stocks has become quite a source of entertainment for the masses.

But what is entertaining for some is completely intimidating to others. The latter may be especially true for those who are new to investing, are nearing retirement, or have been hurt by volatility in the past.

If you are planning to invest, you may be considering stocks as part of your growth plan. If you’re currently invested, you may already have some low- and high-volatility stocks in your portfolio.

No matter the case, understanding volatility is key to being a good stock market investor. That means knowing what volatility is, what causes volatile stocks, and what to do when the market is volatile.

What Is Volatility in Stocks?

Many of us understand the idea of volatility, even if the effect on our money isn’t immediately clear. For example, when we describe a person as volatile, it means that this person has a temperament that is liable to change rapidly and unpredictably—and generally, for the worse.

But what exactly does volatility mean in stocks? Volatility in the market is a similar concept. The price of stocks can change quickly, for any reason. And while volatility in the stock market is usually used to describe a large movement to the downside, volatility also happens to the upside. These precipitous ups and downs are why stock market volatility is often referred to as a roller coaster.

The term “volatile” can be used to describe the stock market as a whole or a specific type of stock, such as technology stocks. It can also be used to describe individual stocks.

In the stock market, volatility is another word for risk. So, the higher the volatility, the riskier the investment. The volatility of an investment is often measured by its standard deviation of returns as compared to a broader market index or even it’s own past returns.

Standard deviation is a calculation that determines the extent a data point deviates from an “expected value,” which is also known as the mean.

When a figure has a low standard deviation, it indicates that the data points tend to be close to this expected value. Therefore, an investment with a low standard deviation would be considered to have low volatility.

A high standard deviation, on the other hand, indicates that the data points are spread out over a larger range of values. For investments, a high standard deviation generally translates to high volatility.

Using the VIX to Measure Volatility

There are multiple ways for the average investor to track volatility. One of the most popular methods is by tracking the VIX volatility index. The VIX measures short-term volatility of the U.S. stock market via a formula that uses the price of options (calls and puts) based on the S&P 500.

Volatility is one component of how options are priced, so by viewing current prices, it’s possible to derive what level of volatility the market expects.

When there is heightened activity, the VIX generally increases, which implies that investors might expect higher market volatility in the near term future and, correspondingly, larger potential movements in stock prices.

The key to understanding why volatility happens is understanding that stocks are an item for sale in a marketplace, just like anything else for sale in a free marketplace.

A stock is a small percentage of ownership in a publicly-traded company. These parcels of company ownership can be bought and sold by investors on an exchange. And, as is the case in any open marketplace, the forces of supply and demand determine the value of the stock.

When there is major volatility to the downside—i.e. when stocks are crashing—it could be because a lot of people are hoping to sell their stock and in order to find a buyer on the other side, they are forced to accept a lower price than they may have hoped. This lack of demand for a stock (or for all stocks) can put downward pressure on the value of the stock.

If buying and selling causes volatility in the market, what causes investors to buy and sell? A great question—and one without a perfect answer. Each investor is motivated to buy and sell based on different factors.

In fact, the reason you might decide to sell a stock may be the same reason leading someone else to buy it. Each investor makes selections through their own subjective lens. That said, when investors agree on something in states of mass panic or hysteria, we tend to see significant swings in the market.

Just as buying and selling cause volatility for the stock market in general, it can also be true for particular sectors of the market or for individual stocks. Often, you’ll see high-volatility stocks within industries that boom and bust alongside the greater economy.

How Is Volatility Reflected in Your Investing?

Let’s pretend that it’s the year 2007, and you have a portfolio of $100,000 invested in the U.S. stock market using a fund that seeks to match the performance of the S&P 500 index. Then, hypothetically, comes one of the largest downturns in stock market history.

From the highest point to the lowest, the S&P 500 is down 57% —and your investments are down equally as much, which means your hypothetical portfolio is now reflecting a figure of $43,000 back to you.

This kind of drop in the stock market can be painful to even the savviest and most experienced investor. And it might feel disheartening to go through such a loss.

If you want to invest in the stock market, it’s a good idea to be prepared for such volatility. It’s likely that over time, as you review your account, you will see the number in front of you fluctuate.

In mentally preparing for stock market investing, remember that volatility doesn’t just happen on the downside; it also happens on the upside. We don’t get to have the good kind of volatility—volatility to the upside—without volatility to the downside.

How Much Volatility Is Normal?

While swings of between 10% and 30% are more common than what happened in 2008, a 50%, or more, move to the downside is not outside the realm of what is possible in the stock market. But as painful as stock market volatility can be, it’s a natural and normal part of stock market investing.

The U.S. stock market has returned about 10% annualized over time . But remember that 10% is an average—usually, stock market returns are much higher or lower. For example, while 2008 closed out the calendar year at -38% , the following year, 2009, came in at a positive 23% (as measured by the S&P 500).

Looking at the history of returns in the stock market is arguably our only guide for understanding what amount of volatility is normal. While it’s never a good idea to assume the future will play out like the past, it’s all we have to ground our understanding of the stock market’s volatility.

And the S&P 500 index is among the most common measures of the stock market. However, it’s possible that future volatility can be much higher or lower than it has been in the past.

Since World War II, the S&P 500 has measured 11 drops of more than 20% . These prolonged downturns of 20% or more are considered “bear markets,” which is investor lingo for bad markets. The following measures are from the highest point to the lowest point of the downturn (not by calendar year):

Peak (Start)

Return

May 29, 1946 -30%
August 2, 1956 -22%
December 12, 1961 -28%
February 9, 1966 -22%
November 29, 1968 -36%
January 11, 1973 -48%
November 28, 1980 -27%
August 25, 1987 -34%
July 16, 1990 -20%
March 27, 2000 -49
October 9, 2007 -57

According to this data, bear markets can happen as close together as two years and as far apart as nearly 12 if you count the current bull (positive, good) market run. And even during positive or good years, smaller fluctuations (such as 5% or 10% to the downside) can happen at any time.

Handling Stock Market Volatility

The first step to handling stock market volatility is to know exactly what you are getting yourself into. If you are investing in the stock market, there will likely be a solid degree of fluctuation in values whether you are invested in low- or high-volatility stocks.

Volatility is not inherently good or bad. How much volatility a portfolio is exposed to should be a product of your goals and risk tolerance. For example, a young person who wants to target high growth may be open to more volatile stocks because generally speaking, higher rewards sometimes come with higher risk.

The reverse is true for someone approaching retirement and who wants the growth of their portfolio to be more stable and not overly prone to huge drawdowns.

If you are nearing retirement, feeling skittish about volatility or investing in general, or have any other reason for wanting a portfolio with lowered volatility, there are several strategies you can utilize to minimize overall volatility in your portfolio.

One strategy you might consider is to diversify your portfolio by integrating bonds or even cash. While bonds do experience volatility, it is generally to a lesser degree than stocks.

Because these asset classes are less correlated to stocks, they may increase in value or remain the same when the stock market is down. In addition to providing actual investment value during stock market downturns, they may also act as an emotional cushion during a difficult time.

Second, you may want to avoid investing in high-volatility stocks. Depending on your investing strategy, this could mean avoiding specific stock picks that are known to be volatile, and it can also mean lessening exposure to certain investing styles or sectors that are considered to be more volatile than average.

Between 1996 and 2017, the sectors with the highest standard deviations were the technology, materials, financials, and energy sectors.

Investing With SoFi

Investing is not something that you have to do on your own. You may want to consider investing with the help of a professional or via an automated service, such as SoFi Automated Investing.

SoFi will help you invest according to your goals and appetite for volatility, and you will have access to credentialed financial advisors—at no additional cost.

If you’d prefer to control your investment portfolio yourself, SoFi Invest® has a solution for that, too: SoFi Active Investing. Active investing allows you to buy and sell stocks, ETFs, and other securities while paying zero SoFi management fees.

No matter how much assistance you need, SoFi Invest has you covered.


External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Third Party Brand Mentions: No brands or products mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third party trademarks referenced herein are property of their respective owners.
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The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

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