We hear the term “volatile” quite a bit when discussing the stock market. And to a certain extent, you probably feel you have a good general understanding of what that means: that stock prices tend to go up and down in response to different events. But there’s a bit more to the story.
What Volatility Is—and What It Isn’t
Put simply, volatility is a measure of how something moves. In the context of the stock market, prices for stocks shift—and sometimes swing dramatically—upward or downward depending on a variety of factors and influences.
Volatility is not a measure of direction. It’s a measure of how wide and how frequently the market or a stock’s price fluctuates.
How Volatility Is Measured
Standard deviation is the statistical mode of measurement for volatility, and it looks at how widely prices are dispersed from the average price. When prices are volatile (moving up and down frequently in a short period of time), the standard deviation returns a rising value. If prices are more stable, the standard deviation value dips.
Many active investors keep an eye on the Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, which is a measure of expected volatility in the next 30 days. The VIX is also known as the “fear gauge,” because if it rises significantly, investors start to worry.
Types of Volatility
We often think of volatility as what’s happening in the moment or over the course of a single day of trading. But there are two types of volatility: Historical and implied.
- Historical volatility, also known as realized volatility, has already occurred and its results are concrete. Price fluctuations have already taken place and been measured. This volatility is reported on the scale of low, medium or high, and takes place routinely any day the markets are open.
- Implied volatility, on the other hand, is about perception, or what investors expect will happen. How much will an individual stock or the market move? The answer is calculated based on the prices of call and put options (options contracts for buying or selling).
Causes of Volatility
The major stock indices (such as the S&P 500 index) don’t typically fluctuate more than 1% in either direction on a given day. However, at the start of the COVID-19 pandemic, price movements yo-yoed more than 5% each day.
The reason? Uncertainty. The global event was unprecedented, and no one knew what would happen.
In another well-known unprecedented event, the stock market crash of 1929 that kicked off the Great Depression, the two-week historical volatility soared to 127%. Black Monday, in 1987, saw a one-day decline of more than 20% in the major averages, and short-term volatility hit more than 130%. Short-term volatility of the S&P 500 during the Great Financial Crisis of 2009 exploded to 97%.
These events may be few and far between, and yet the effects of the extreme volatility were far-reaching. Other circumstances that can cause uncertainty and lead to market volatility include anticipated economic data, company earnings reports, political elections, and societal events.
Volatility and Your Investments
Not all asset classes behave the same when it comes to volatility. For example, blue chip stocks are less prone to major swings in price, while tech stocks have in the past been known to vary up or down more wildly. That’s why diversification and a balanced portfolio matter so much.
When it comes to your investments, there are two key things to know and remember: First, volatility and risk are not the same thing. Second, it’s important to have a financial plan in place that helps you mitigate any impact of volatility.
Volatility, Risk, and the Importance of a Financial Plan
For stock traders who aim to buy low and sell high all day long, volatility has an immediate impact on their daily decisions and is directly related to their appetite for risk.
But for the average investor who is building wealth for retirement, volatility takes on a different tone. A long-term investor with a solid financial plan and balanced portfolio doesn’t need to be concerned in the same way about daily price swings. Volatility is an inevitable part of investing.
Volatility can cause investors to react emotionally to the market, but having a financial plan in place and a trusted wealth advisor by your side is essential when it comes to making smart decisions and weathering stock market volatility.
Market volatility can be scary, but with Ironwood Wealth Management’s disciplined, goal-oriented approach to managing your portfolio, we can help you devise and stick to the investment strategy that’s best for you. Contact us today