Our team of writers and editors utilized our in-house natural language generation platform to assist in creating this article, allowing them to focus on providing information that is uniquely valuable. The article underwent a thorough review, fact-checking, and editing process by our editorial staff before being published.
Market volatility refers to the extent to which the price of a security or index fluctuates over a period of time. Market volatility can be triggered by various factors, such as unfavorable economic news like increasing unemployment, decisions made by central bankers such as the Federal Reserve, or unexpected events like a sudden surge in oil prices. Sometimes, volatility is a result of market panic, where traders rush to sell before others, leading to a stock market crash.
Investors who prefer a buy-and-hold strategy may opt to steer clear of volatile stocks as their value can be difficult to maintain. However, some traders may see volatility as an opportunity to profit by engaging in active trading to capitalize on price fluctuations.
Understanding market volatility is crucial for investors and traders to make informed decisions about their investments. Here’s an overview of what volatility is, how it is measured, and its impact on investors.
Measuring Market Volatility
There are two primary methods used to measure market volatility: standard deviation and beta:
- Standard deviation indicates how much a price fluctuates over a specific period relative to the asset’s average price change.
- Beta is a measure of volatility that compares a stock’s volatility to a benchmark, such as the S&P 500 Index. Beta reveals how volatile a stock is in relation to the overall market.
Market volatility is defined by the standard deviation of returns. Returns are calculated over a designated time frame, such as a month or a year. Standard deviation assesses how different an individual stock’s returns are compared to its average return during that specific period.
A stock’s standard deviation is typically reported in percentage terms, offering a concrete level of volatility for the asset.
In contrast, beta provides a relative gauge of volatility by comparing a stock or other assets to the S&P 500 Index. The results indicate movement in relation to the base index:
- A stock with a beta of 1 would be expected to move in alignment with the overall market.
- A stock with a beta of 2 would experience price movements twice as significant as the market as a whole.
- A stock with a beta below 1 suggests it is anticipated to be less volatile than the index overall.
- Conversely, a negative beta indicates the asset moves in the opposite direction of the market.
However, both standard deviation and beta measure volatility and not the risk associated with an investment’s cash flows or a company’s fundamental business risk.
Additionally, some market observers rely on the CBOE Volatility Index (VIX), known as the “fear index,” to assess overall market volatility, albeit tracking a different type of volatility. The VIX evaluates the anticipated fluctuation for the S&P 500 Index based on the implied volatility of near-term S&P 500 index options.
The VIX is computed from an average of the costs of those options, and its calculation is one of the most closely monitored indicators for predicting future market volatility. The VIX is derived from a weighted average of the option prices of the broad S&P 500 index, which is based on the average stock prices of the 500 largest U.S. companies.
Impact of Market Volatility on Investors
Market volatility can significantly affect investors. For some, the uncertainty and rapid changes in market conditions can be unnerving. It is common for investors to feel anxious about their investments or frustrated by recent losses, leading to decisions that may negatively impact their long-term returns.
- Anxiety: Feeling like the market is working against you is a common sentiment. Historically, the stock market has shown overall growth, and you may perceive yourself falling behind its upward trajectory while striving to build your wealth over time.
- Increased tax liability: Selling positions with capital gains due to volatility could trigger capital gains taxes, reducing your profits.
- Heightened expenses and commissions: Engaging in frequent trading may result in increased costs, especially when dealing with options.
- Short-term decisions: Many investors sell to cut losses during volatile periods, missing out on potential market returns. This can lead to buying back into the market at higher prices, essentially “selling low and buying high.”
There are strategies to navigate through volatile market phases, including managing your emotions:
- Stay committed: Panic selling during a market downturn is typically the worst approach. Selling off positions may hinder your ability to purchase stocks at advantageous prices.
- Maintain a diversified portfolio: Diversifying with a mix of stocks and bonds can help reduce volatility compared to the broader stock market.
- Exercise patience: Avoid making impulsive decisions when the market is experiencing volatility.
- Remain level-headed during market upswings: Refrain from getting overly excited about market gains. A market decline often presents buying opportunities, while a surge calls for resisting the temptation to buy.
Key Takeaway
The stock market inherently exhibits volatility, with prices fluctuating unpredictably. Market volatility can present attractive prospects for seasoned traders who can capitalize on price swings and market anxiety. Maintaining a diversified portfolio with index funds or broadly diversified ETFs is a prudent way to mitigate the impact of market volatility on your investment portfolio.