“Stocks have taken a nosedive!”
“Stocks are soaring to new heights, breaking previous records!”
Conversations about the stock market seem to be intrinsically tied to comments about its volatility. The choppy nature of share prices can be intimidating to some investors, especially those who are just beginning to invest, nearing retirement or have been burned by volatility in the past.
Stocks are considered to be an important part of an investment portfolio, and they can be a tremendous source of wealth building for investors. And while there are some lower volatility equities versus higher volatility ones, it’s undeniable that they are a turbulent asset class.
That’s why understanding volatility is key to being a good stock investor. Here’s a closer look at what volatility exactly is, what causes volatility in stocks, and what to do when the market is volatile.
What Is Stock Volatility?
When a person is described as volatile, it means that they have a temperament that is prone to changing rapidly and unpredictably—and generally, for the worse.
Volatility in the stock market is a similar concept. Share prices can change quickly, for a multitude of reasons. And while volatility in the stock market is usually used to describe large moves to the downside, volatility can also happen to the upside.
Volatility is often synonymous with risk for investors. That’s because investors generally prefer a steady source of returns as opposed to an erratic one. However, volatility in the equity market can represent significant opportunities for investors as well. For instance, when investors might “buy the dip”–purchase shares when there’s a bit of volatility that drives prices lower momentarily.
How to Measure Stock Volatility
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.
A low standard deviation indicates that the data points tend to be close to this expected value. Therefore, an investment with a low standard deviation is considered to have low volatility. A high standard deviation indicates that the data points are spread out over a larger range. For investments, a high standard deviation generally translates to high volatility.
Investors can also monitor the risk in their stock holdings by finding their portfolio beta–its sensitivity to price swings in the broader market. Beta is financial risk that stems from the entire market and can’t be diversified away.
Another popular measure of tracking volatility is the Cboe Volatility Index, otherwise known as the VIX. The VIX measures short-term volatility of the U.S. stock market via a formula that uses options trading or the price of call and put contracts based on the S&P 500 Index.
What Causes Market Volatility?
The stock market is known for having boom-and-bust cycles, which is another way of describing volatility. Here’s what typically transpires: long periods of booming share prices tend to drive investors to take on more risk by buying up more speculative positions. They thus make themselves more vulnerable to shocks in the financial system, leading to market busts.
When it comes to individual stocks, events tied to the company’s performance such as earnings or a product announcement can drive volatility in its shares. But when it comes to broader market volatility, a variety of causes can trigger bigger swings in share prices: monetary policy, fiscal policy or uncertainty over political events like Brexit or presidential elections.
For instance, from 2012 to 2020, equity markets worldwide were characterized by a prolonged period of unusual quiet, as the Federal Reserve, European Central Bank and Bank of Japan, as well as other central banks across the world, conducted stimulus programs and eased monetary policy–putting a blanket of calm across the stock market.
Other factors that can drive volatility include liquidity and the derivatives market. Liquidity is the ease with which an asset can be bought and sold without affecting prices. If an asset is tough to unload and gets sold at a significantly lower price, that could inject fear into the market and cause other investors to sell as well, ramping up volatility.
Separately, there’s sometimes a debate whether derivatives–contracts that are based on an underlying asset–can cause volatility. For instance in 2020, investors debated whether large volumes of stock options trading caused sellers of the options, typically banks, to hedge themselves by buying stocks, exposing the market to sudden ups and downs when the banks had to purchase or sell shares quickly.
How to Manage Volatility When Investing
Let’s pretend that it’s 2007, and an investor has money invested in the U.S. stock market. This investor is unfortunately facing one of the largest stock market crashes in history. From the highest point to the lowest, the S&P 500 fell down 57% at that time.
This kind of drop in the stock market isn’t common but can be traumatic even for the savviest and most experienced investor. So the first step to handling stock market volatility is to understand that there will definitely be some degree of price fluctuation. The second step is to know one’s risk tolerance and financial goals, then invest accordingly.
For example, a younger investor in their 20s might want to target high growth and may be open to more volatile stocks. Generally speaking, higher rewards sometimes come with higher risk. The reverse is true for someone approaching retirement and who wants stable returns from their portfolio. There are some strategies a more cautious investor can take to mitigate volatility in their portfolio. One way is diversification.
Here is why portfolio diversification matters: lower volatility stocks, such as utility or consumer staple companies can add stability to a stock portfolio. Meanwhile, energy, technology and consumer discretionary shares tend to be more turbulent because their businesses are more cyclical, or tied to the broader economy in general.
Another way to diversify one’s portfolio is to add bonds or even cash. When it comes to bonds vs. stocks, the former is a less volatile asset class because they are a type of loan investment. There is a middle ground as well: high-yield bonds. This investment category can generate bigger returns than bond investments like Treasurys but are also more volatile, while being less choppy than equities.
How Much Stock Volatility Is Normal?
The average stock market return in the U.S. has been 10% annualized over time. But 10% is an average—share prices returns can be much higher or lower. For example, equity prices as measured by the S&P 500 closed out 2008 down 38%. Then, in 2009, they rallied 23%.
Past performance is not indicative of future returns but looking at history can help an investor gauge how much market fluctuation is normal. Since World War II, the S&P 500 has posted 11 drops of more than 20%. These prolonged downturns of 20% or more are considered “bear markets.”
The table below shows the S&P 500’s returns from the highest point to the lowest point in a downturn. 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 market run.
|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%|
|August 25, 1987||-34%|
|March 27, 2000||-49%|
|October 9, 2007||-57%|
Stock volatility is the pace at which the market moves up or down during a certain period. It’s a complex topic that often sparks debate among investors, traders and academics about what causes it. While equities are considered an important part of any investment portfolio, they are also known for being volatile, and some degree of turbulence is something most stock investors have to live with.
However, for long-time investors, periods such as when the dot-com bubble burst in the early 2000s and during the financial crisis in 2008 are defining moments when market volatility seemed to get out of hand. While such events are rare, investors should make sure to diversify their portfolios, monitor the share prices of their stock holdings, and seek protection when possible.
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