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Market volatility refers to the degree to which the price of a security or the index that it tracks changes over a period of time. It’s important for investors and traders to understand market volatility in order to make informed decisions about their investments.
Investors who prefer to buy and hold a stock, rather than trade, may want to avoid volatile stocks, as volatility makes it harder to maintain the value of the investment. But investors may also want to take advantage of volatility by trading in and out of positions to profit from these changes.
Here’s what volatility is, how it’s measured and how it can affect investors.
How market volatility is measured
There are two main ways to measure actual market volatility, standard deviation and beta:
- Standard deviation shows how much a price changes over a time period relative to the asset’s average change in price.
- Beta is a measure of volatility that compares a stock’s volatility against a benchmark, such as the S&P 500 Index. Beta is a measure of how volatile a stock is relative to the overall market.
Market volatility is defined by the standard deviation of the returns. The returns are calculated over a given period of time, such as a month or a year. The standard deviation measures how different a stock’s individual returns are compared to its average return over that specific period.
A stock’s standard deviation would typically be reported in percentage terms, giving an absolute level of volatility for the asset.
In contrast, beta provides a relative measure of volatility, comparing a stock or other assets against the S&P 500 Index. So the results provide an indication of movement in terms of the base index:
- A stock with a beta of 1 would be expected to move the same amount as the overall market.
- A stock with a beta of 2 would be expected to have price moves twice as big as the market as a whole.
- A stock with a beta of less than 1 means it’s expected to be less volatile than the index as a whole.
- Alternatively, a negative beta indicates that the asset moves in the opposite direction of the market.
However, both standard deviation and beta are measures of volatility, but not the risk of an investment’s cash flows or a company’s fundamental business risk.
In addition, some market watchers use the CBOE Volatility Index (VIX), popularly known as the “fear index,” to gauge overall market volatility, though it’s tracking a different kind of volatility. The VIX measures the expected fluctuation for the S&P 500 Index, based on the implied volatility of near-term S&P 500 index options.
The VIX is calculated from an average of the cost of those options, and its calculation is one of the most closely watched indicators to predict future market volatility. The VIX is based on a weighted average of the option prices of the broad S&P 500 index, which is based on the average of the stock prices of the 500 largest companies in the U.S.
How market volatility affects investors
Market volatility can have a big impact on investors. For some, the uncertainty and rapid change in market conditions can be unsettling. It’s not unusual for investors to feel anxious about their investment or frustrated about recent losses, leading to decisions that can hurt your long-term returns.
- Anxiety: You may feel like the market is against you. The stock market has historically risen over time, and you may feel like you’re losing out to the market’s overall upward trajectory while you’re trying to build your wealth over time.
- Increased tax hit: If volatility has you selling positions with a capital gain, it could trigger capital gains taxes, costing you some of your profit.
- Increased commissions and costs: If you’re trading in and out of the market, you may run up higher costs, especially if you’re buying options.
- Short-term decisions: To cut losses, many investors sell, so they’ll be unable to enjoy the market’s returns. They may be unable to buy back into the market at a lower price, meaning they may be “selling low and buying high.”
But there are ways to help get through a volatile period, such as managing your temperament:
- Stay in it to win it: The worst way to get through a market downturn is to panic and sell. And if you sell, you’re unlikely to buy stocks at a good price.
- Keep a diversified portfolio: A diversified portfolio, with both stocks and bonds, tends to be less volatile than the stock market as a whole.
- Take time to breathe: Don’t make rash decisions when the stock market is volatile.
- Stay even-tempered during the good times: Don’t get overly excited about the market’s gains. A market downturn means it’s usually a good time to buy stocks, while a market surge means it’s a great time to resist the urge to buy.
Bottom line
The stock market is inherently volatile. Stock prices go up and they go down, sometimes with little rhyme or reason. Market volatility can provide attractive buying opportunities for experienced traders who know how to capitalize on price swings and panic. But for the average investor, market volatility is something you likely want to avoid. Staying diversified with index funds or broadly-diversified ETFs is one way to reduce the risk of market volatility throwing your portfolio into chaos.
