Volatility is a measure of how much and how often a security’s price or a market index moves up or down over time. Higher volatility can mean higher risk, but it also has the potential to generate bigger rewards for investors. Meanwhile, lower volatility is typically correlated with lower risk and lower returns.
Developing a volatility investing strategy can make it easier to maximize returns while managing risk as the market moves from bullish to bearish and back again. Understanding the various stock market sectors and how they react to volatility is a good place to start. This can help with building a portfolio that’s designed to withstand occasional market dips or in the worst-case scenario, a recession.
What Causes Volatility in the Stock Market?
To implement a volatility investing plan it helps to first understand what causes fluctuations in stock prices to begin with. Stock market volatility can ebb and flow over time, and how high or low it is can depend on a number of factors. Some of the things that can push volatility levels higher include:
• Political events, such as elections
• Release of quarterly earnings reports
• Natural disasters
• The bursting of a stock market bubble
• Crises that in foreign countries
• Federal Reserve adjustments to interest rate policy
• News of a merger or acquisition
• Changes to fiscal policy
• Initial Public Offerings (IPOs) hitting the market
• Excitement over meme stocks
A global pandemic can also spark volatility, as evidenced in the mini market crash that occurred early in 2020. Coronavirus fears prompted the end of the longest bull market in history, sending stocks into a bear market.
The downturn was significant enough that the National Bureau of Economic Research Business Cycle Dating Committee dubbed it a recession. It was, however, the shortest on record, lasting just two months. (By comparison, it took 18 months for the stock market to go from peak to trough during the Great Recession).
Predicting volatility can be difficult, though there is a tool that attempts it. The Cboe Volatility Index (VIX) is a market index designed to measure expected volatility in the stock market. The VIX uses real-time stock quotes to calculate projected volatility over the coming 30 days. The VIX is one factor that goes into the Fear and Greed Index, which measures the emotions driving the stock market.
💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.
Market Sectors and Volatility
The stock market is effectively a pie with 11 different slices called sectors. These sectors represent the various segments of the market, based on the industries and companies they represent. The 11 sectors identified by the Global Industry Classification Standard (GICS) are:
• Information technology
• Health care
• Consumer discretionary
• Consumer staples
• Communication services
• Real estate
Some of these sectors include more volatile industries than others, and the share of stocks in those industries within a given portfolio can impact how the portfolio reacts during times of volatility.
Stocks that tend to bear up under the pressure of a downturn or recession are generally categorized as defensive. You may also hear the terms “cyclical” and “non cyclical” used in reference to different market sectors. A cyclical sector or stock is one that’s volatile and tends to follow economic trends at any given time. Non Cyclical sectors or stocks, on the other hand, may outperform when the market experiences a downturn.
What Stock Sectors Do Best During Market Volatility?
Defensive stock market sectors tend to do better when the market is in decline for one reason: they represent things that consumers still need to spend money on, even when the economy is weakening. That means they may be of interest if you’re investing during a recession.
The following sectors tend to do the best during times of volatility:
• Consumer staples
• Health care
Here’s a closer look at how each sector works.
The utilities sector represents companies and industries that provide utility services. That includes gas, electric, and water utilities. It can also include power producers, energy traders, and companies related to renewable energy production or distribution.
Since people still need running water, electricity and heat during a recession, utilities stocks tend to be a safe defensive bet.
The consumer staples sector covers companies and industries that are less sensitive to a changing economic or business cycle. That includes things like food and beverage manufacturers and distributors, food and drug retailing companies, tobacco producers, companies that produce household or personal care items and consumer super centers.
In simpler terms, the consumer staples sector means things like grocery stores, drugstores, and the manufacturers of everyday products. Since people still need to buy food and basic household or personal care items in a recession, stocks from these sectors can do well when volatility is high.
The health care sector includes health care service providers, companies that manufacture health care equipment, distributors of that equipment, health care technology companies, research and development companies and pharmaceutical companies.
Health care is a defensive sector since a recession usually doesn’t disrupt the need for medical care or medications.
💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.
What Sectors and Stocks Are More Volatile?
When a recession sets in, defensive sector stocks can be a good buy. The period before a recession begins is often marked by increased volatility and declining stock prices. The impacts of that volatility may be more deeply felt in these sectors:
• Consumer discretionary
• Communication services
• Information technology
These sectors represent more volatile industries that are more likely to be affected by large-scale market trends. For example, the financial sector suffered a serious blow leading up to the Great Recession. A decline in home prices paired with faulty lending practices prompted widespread defaults on mortgage-backed securities, leading a number of financial institutions to seek government bailout funding.
On the other hand, some of these same sectors do well when the economy is coming out of a recession and entering the early stage of the business cycle. For example, the consumer discretionary sector, which includes things like travel and entertainment, typically rebounds as consumers ease their purse strings and start spending on “fun” again. The industrials and materials sectors may also pick up if there’s an increase in manufacturing and production activity.
Understanding the relationships between individual sectors and the business cycle can make it easier to implement a sector investing approach. With sector investing, you’re adjusting your asset allocation over time to try and stay ahead of the economic cycle.
If you suspect a recession might be coming, for example, a sector investing strategy would dictate shifting some of your assets to defensive stocks. On the other hand, if you believe a recession is about to end and stocks are set to bounce back, you may shift your allocation to include more volatile industries that tend to do better in the early stages of the business cycle.
Recommended: Why You Need to Invest When the Market Is Down
Volatility and Business Cycles
Identifying volatile industries generally means considering which sectors or stocks are most sensitive to changes in the economic cycle. Aside from recessionary periods, the business cycle has three other stages:
The early stage of the business cycle typically represents the initial recovery period following a recession. Consumers may begin spending more money on non essentials as the economy begins to strengthen. This is also called the expansion phase, and it may coincide with periods of inflation.
During the mid stage, the economy begins to hit a peak or plateau with growth leveling off. People are still spending money but the pace may begin slowing down.
The late stage is also called the contraction stage, as economic growth lags. The late stage of the business cycle is usually a precursor to the trough or recession stage.
Volatility is unavoidable but there are things investors can do to minimize the impact to their portfolio. Diversifying with stocks, exchange-traded funds (ETFs), or IPOs could help create volatility hedges.
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