Almost all assets see fluctuations in value over time.
But while price swings are a common phenomenon in most asset classes that exist, they are the most famous in the stock market.
These upward and downward movements in price are known as volatility, which is defined as “a measure of the frequency and severity of price movement in a given market”.
Today’s infographic comes to us from Fisher Investments, and it serves as an introduction to the concept of volatility, along with offering a perspective on volatility’s impact on investments.
Why are certain times more volatile than others?
In the short term, volatility is driven by changes in demand, which is largely related to changes in earnings expectations. These expectations can be affected by:
- Earnings reports
- New economic data
- Company leadership changes
- New innovations
- Herd mentality
- Political changes
- Interest rate changes
- Market sentiment swings
- Other events (economic, political, etc.)
Often the media and investors assign certain narratives to price changes, but the reality is that the stock market is very complex, and has many underlying factors that drive movements.
What ultimately matters for volatility is demand: if stocks move up or down on a given day, we can say definitively that demand for stock was more (or less) than stock supply.
Technically speaking, volatility is a statistical measure of the dispersion of returns for a given security or market index over a specific timeframe.
In other words, two stocks may have the same average rate of return over a year, but one may have daily moves of 1%, while the other may jump around by 5% each day. The latter stock has a higher standard deviation of returns, and thus has higher volatility.
Here’s what you need to know about standard deviation, which is a common measure of volatility:
- Roughly 68% of returns fall within +/-1 standard deviation
- To calculate standard deviation, differences must be squared. This means negative and positive differences are combined
- Standard deviation tells you how likely a particular value is, based on past data
- Standard deviation doesn’t, however, show you the direction of movement
This all gets more interesting as we look at the market as a whole, in which thousands of stocks (each with their own individual volatility) are moving up and down simultaneously.
Now that you can see how volatility plays out with individual stocks, it makes sense that market volatility is the overall volatility from the vast collection of stocks that make up the market.
In the United States, the most watched stock market index is the S&P 500 – a collection of 500 of the largest companies listed in the country. One measure of the volatility of the S&P 500 is the CBOE Volatility Index, or as it is known by its ticker symbol, the VIX.
Volatility and market sentiment in the overall market are important, because humans tend to experience the pain of loss more acutely than the upside of gains – and this can impact short-term decision making in the markets.
Negative price swings in the wider market can be distressful and unnerving for investors, and high volatility does present some challenges:
- Uncertainty in the markets can lead to fear, which can lead investors to make decisions they may otherwise not make
- If certain cashflows are needed at a later date, higher volatility means a greater chance of a shortfall
- Higher volatility also means a wider distribution of possible final portfolio values
That said, volatility also represents a chance of better returns than expected – and for long-term investors that are patient, volatility can help drive outcomes.