Conversations about the stock market are usually tied to comments about its volatility — how frequently share prices go up and down. 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 an important part of an investment portfolio and 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.
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What Is Stock Volatility?
Volatility in the stock market occurs when there are big swings in share prices. Share prices can change quickly for a multitude of reasons. And while volatility in the stock market usually describes significant declines in share prices, 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 rather than an erratic one.
However, volatility in the equity market can also represent significant opportunities for investors. For instance, investors might take advantage of volatility to buy the dip, purchasing shares when prices are momentarily lower.
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How to Measure Stock Volatility
Investors often measure an investment’s volatility by its standard deviation of returns compared to a broader market index or past returns. Standard deviation is a calculation determining the extent to which a data point deviates from an expected value, 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 the 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 the 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.
Long periods of booming share prices tend to drive investors to take on more risk by entering into more speculative positions and buying riskier assets; investors and traders don’t want to miss out on the rally. They thus make themselves more vulnerable to shocks in the financial system, leading to market busts when investors need to sell their holdings en masse when the market is shaky.
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Regarding 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, various causes can trigger more significant swings in share prices, like changes in economic policy or uncertainty over geopolitical events.
For instance, the early stages of the coronavirus pandemic in February and March 2020 brought shockwaves into the markets. As economies across the globe shut down, investors began to sell off risky assets, bringing about high levels of volatility in the financial markets. Governments enacted extraordinary fiscal and monetary stimulus programs to calm this volatility and bring stability to the markets.
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, 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. Unfortunately, this investor is facing one of the largest stock market crashes in history. The S&P 500 fell by 57% during this crash.
This drop in the stock market isn’t typical, but it can be traumatic even for the savviest and most experienced investor. So the first step to handling stock market volatility is understanding that there will be some price fluctuation. The second step is to know one’s risk tolerance and financial goals, then invest and readjust a portfolio accordingly.
Generally speaking, higher rewards sometimes come with higher risks. For example, younger investors in their 20s might want to target high growth and be open to more volatile stocks. The reverse is true for someone approaching retirement who wants stable portfolio returns. 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.
Another way to diversify one’s portfolio is to add bonds, alternative investments, or even cash. When deciding to add bonds or stocks to a portfolio, it’s helpful to know that the former is generally a less volatile asset class.
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, as measured by the S&P 500, equity prices closed out 2008 down 38%. Then, in 2009, they rallied by 23%.
Past performance is not indicative of future returns, but looking at history can help an investor gauge how much volatility and market fluctuation is normal. Since World War II, the S&P 500 has posted 12 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 average a decline of 34%, lasting a little more than a year. Bear markets have occurred as close together as two years and as far apart as nearly 12 years.
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 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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