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Volatility

The value of the stock market goes up and down, meaning that those invested in stocks and funds gain and lose money over time without taking any action. This movement is a feature, not a bug — the stock market is designed to continuously shift and change.

This up-and-down fluctuation in the value of the market, and of individual stocks and funds within the market, is called volatility.

What Is Volatility?

Volatility is a measure of how much the price of a stock or the value of the market changes over a specific period. That is to say, it’s an indication of how big, erratic, and rapid the up-and-down swings are.

The statistical measure typically used to assess volatility is standard deviation, which indicates how far the highs and lows stray from the average price. A stock or fund whose value is cratering and/or skyrocketing is very volatile, while one that shifts only a little does not have much volatility.

Volatility is a term that has negative connotations; many people use it to indicate a downward swing or crash in the market. However, volatility makes no judgement. The concept also includes upswings, which can help investors make money.

The idea to take away is that the greater the volatility, the riskier the investment. More than anything, volatility is an indication of short-term uncertainty.

How To Assess Volatility

You can assess the volatility of an individual stock or fund by looking at a metric called beta, which measures its historical volatility in relation to the S&P 500 index. If the beta is greater than one, the stock or fund has historically been more volatile than the S&P 500. A beta less than one indicates that the stock or fund has historically been more stable than the S&P 500. And a negative beta — an unusual occurrence — shows that the stock or fund has typically moved opposite the S&P 500.

You can assess the market as a whole by looking at the Chicago Board Options Exchange Volatility Index (VIX), which measures how much volatility is expected in the market in the next 30 days. The specific number the VIX lands on doesn’t really matter; its movement is more significant — if the VIX jumps upward, that usually means that a lot of volatility is on the way. This is why its other names are “Fear Gauge” and “Fear Index.”

Implied Volatility vs. Historical Volatility

Traders might look at two different types of volatility when judging what is likely to happen. Implied (or projected) volatility is a prediction of how volatile the market will be over a certain period. This metric is calculated using the prices of options. Since this is a prediction, it isn’t set in stone; the market may move differently than an assessment of implied volatility suggests it will.

Historical (or statistical or realized) volatility is a measure of how volatile a stock has been in the past during a particular period. It usually measures volatility by looking at the change in the closing price from one date to another, usually 10 to 180 trading days apart.

How Much Market Volatility Is Normal?

It is common and expected for markets to be volatile on a regular basis. During any given year, investors typically expect returns to deviate some 15% from average. Periodically — say once every five years — you’re likely to face more volatility, perhaps around 30%.

The amount of volatility that’s normal in a market is related to the general trend of the market at that time. The market can be either “bullish” (trending upward) or “bearish” (trending downward). Bullish markets are typically fairly stable, while bearish markets often have high volatility, with unpredictable swings that end up moving the market downward.

How to Handle Market Volatility

To be a savvy investor, you must learn to be comfortable with volatility. A cardinal rule of investing is to resist selling a stock or fund as soon as the price plunges. In fact, that old saying “buy low, sell high” should be your guiding principle — when the price takes a hit, it’s a better time to invest than to sell.

Historically when the market falls a lot, it comes back stronger — generating large gains once it recovers. Knowing this can help you avoid the mistake of selling when you shouldn’t. Also keep the following advice in mind:

  • Stick to a long-term plan: If you need the funds you’re investing in the near term, then you shouldn’t be in the market in the first place. The stock market is best left to those who can let their money weather the volatility and see eventual gains over years of investing.
  • Buy low: Purchasing stocks and funds that have had a strong track record during downturns is like buying good products at a discount. If you do so with the long term in mind, you may well eventually see a large return from the decision.
  • Keep some liquidity in your finances: You can remain sanguine about market volatility if you don’t need to pull your money out right away. You should have enough cash on hand in an emergency fund or other savings account so that you can safely leave your portfolio alone, even when prices are dipping downwards.
  • Rebalance your portfolio: Since volatility can result in changes to the relative values of the investments in your portfolio, it’s a good idea to rebalance periodically to make sure your asset allocation remains where you want it.
  • Get out of the market if you’re about to retire: Investors who are close to retirement will find too much risk in the naturally volatile stock market. They should put up to two years’ living expenses in non-market assets such as bonds, cash, home equity lines of credit, and cash values in life insurance.

How ETFs and Mutual Funds Can Protect You Against Volatility

One way to volatility-proof your investments is to choose some well-diversified ETFs or mutual funds, which can offer some downside protection and reduce your risk. Since these funds bundle multiple stocks — sometimes as many as 1,000 — they are likely to be somewhat insulated from the risk presented by volatility.

While both ETFs and mutual funds can help diversify your portfolio and reduce your risk, ETFs may be a better option for responding to volatility because of the speed of transaction they enable. It can take several days to make changes to a traditional mutual fund, while ETFs are traded like stocks and can transact much more quickly. This means you can take advantage of dips in the market by quickly investing more in your ETFs, or, if you’re so inclined, sell your shares quickly at a high point.

How Volatility Can Benefit Investors

While some investors may think they can use volatility to their advantage by waiting for stocks and funds to dip down before buying, then immediately selling at the next high point, it has proven difficult for such active management to beat the returns of a well-balanced mutual fund or ETF that tracks the market. Many investors therefore swear by a buy-and-hold strategy, which requires keeping investments long term so they rise gradually with the market.

Using a buy-and-hold strategy allows investors to double down on their investments in solid companies or ETFs when the market is at a low point due to volatility, setting themselves up for larger cumulative gains over time.

Those who do wish to use volatility to their advantage in a more active way have the potential to make big profits fast. However, you need to be very comfortable with risk and use some strategies to mitigate it. When investing during a volatile market with the intention of trading in the near term to make a profit, consider your position size and stop-loss placement. Doing smaller trades and using a wider stop-loss than usual can reduce your risk. Another good strategy is to seek out trending stocks or funds that have shown strong growth but haven’t accelerated faster than the broader market..

Takeaways About Volatility

  • Volatility is how much the price of a stock or fund moves away from the average price, either up or down or both, in a given period of time.
  • Volatility is a normal part of the stock market; investors can expect 15% movement away from the market’s average in any given year, and will see greater fluctuation periodically.
  • Investors can weather volatility by sticking to a long-term plan, using a buy-and-hold strategy, and maintaining enough liquidity in their finances.
  • Investors can benefit from volatility by buying on downswings and then holding onto their assets over time as the market gradually climbs.
  • Those who want to use volatility to make big gains need to be very comfortable with risk and use strategies to reduce it.

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 The information and data are as of the July 13, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.

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