What is volatility?
Volatility is an investment term that describes when a market or security experiences periods of unpredictable, and sometimes sharp, price movements. People often think about volatility only when prices fall, however volatility can also refer to sudden price rises too.
How is volatility calculated?
Volatility measures price movements over a specified period.
In statistical terms, volatility is the standard deviation of a market or security’s annualised returns over a given period - essentially the rate at which its price increases or decreases.
If the price fluctuates rapidly in a short period, hitting new highs and lows, it is said to have high volatility. If the price moves higher or lower more slowly, or stays relatively stable, it is said to have low volatility.
Historical volatility is calculated using a series of past market prices, while implied volatility looks at expected future volatility, using the market price of a market-traded derivative like an option.
What causes volatility?
Some of the things that can cause volatility include:
1. Political and economic factors
Governments play a major role in regulating industries and can impact an economy when they make decisions on trade agreements, legislation and policy. Everything from speeches to elections can cause reactions among investors, which influences share prices.
Economic data also plays a role, as when the economy is doing well, investors tend to react positively. Monthly jobs reports, inflation data, consumer spending figures and quarterly Gross Domestic Product (GDP) calculations can all impact market performance. In contrast, if these miss market expectations, markets may become more volatile.
2. Industry and sector factors
Specific events can cause volatility within an industry or sector. In the oil sector, for example, a major weather event in an important oil-producing area can cause oil prices to increase. As a result, the share price of oil distribution-related companies may rise, as they would be expected to benefit, while the prices of those that have high oil costs within their business may fall.
Similarly, more government regulation in a specific industry could result in stock prices falling, due to increased compliance and employee costs that may impact future earnings growth.
3. Company performance
Volatility isn’t always market-wide and can relate to an individual company.
Positive news, such as a strong earnings report or a new product that is wowing consumers, can make investors feel good about the business. If many investors look to buy it, this increased demand can help to raise the share price sharply.
In contrast, a product recall, data breach or bad executive behaviour can all hurt a share price, as investors sell off their shares. Depending on how large the company is, this positive or negative performance can also have an impact on the broader market.
Volatility is a normal part of long-term investing
There is plenty to unnerve markets and cause volatility, from changes in commerce to politics, to economic outcomes and corporate actions.
Yes, it might be unsettling, but it’s all ‘normal’.
When investors are prepared at the outset for episodes of volatility on their investing journey, they are less likely to be surprised when they happen, and more likely to react rationally.
By having the mindset that accepts volatility as an integral part of investing, investors can prepare themselves and remain focused on their long-term investment goals.
Market corrections can create attractive opportunities
Volatility is not always a bad thing, as market corrections can sometimes also provide entry points from which investors can take advantage.
If an investor has cash and is waiting to invest in the stock market, a market correction can provide an opportunity to invest that cash at a lower price. Downward market volatility also offers investors who believe markets will perform well in the long run the opportunity to buy additional shares in companies that they like, but at lower prices.
A simple example may be that an investor can buy for $50, a share that was worth $100 a short time before. Buying shares in this way lowers your average cost-per-share, which helps to improve your portfolio’s performance when markets eventually rebound.
The process is the same when a share rises quickly. Investors can take advantage of this by selling out, the proceeds of which can be invested in other areas that offer better opportunities.
By understanding volatility and its causes, investors can potentially take advantage of the investment opportunities that it provides to generate better long-term returns.