Have you ever wondered why some investors love market volatility while others fear it? Volatility is the degree of variation in the price of a stock or an index over time. However, not all kinds of volatility are bad. It can be your friend or a foe, depending on how you use it.
This article will show you how the correct market volatility can help you increase your equity returns by taking advantage of market fluctuations and diversifying your portfolio. Also, you will learn some tried and tested strategies to profit from upswings and downswings in markets.
Whether you are a beginner or an expert, this article will help you understand and correctly harness the power of volatility in your investing journey.
Understanding Market Volatility
Market volatility is a statistical measure of how much the price of a stock or an index fluctuates over a fixed period. It can be simply understood as a yardstick to measure how much the price changes relative to other periods or assets.
Market volatility is mainly associated with risk, as higher volatility means higher uncertainty and potential losses. However, volatility can also be a source of opportunity, creating attractive entry and exit points for investors willing to take calculated risks.
How to Measure Stock Market Volatility?
Market Volatility is traditionally measured using the method of Standard Deviation of returns of assets over a given period or compared to other assets. The standard deviation is a statistic that shows how much the returns vary from the average. The standard deviation measures how much the asset price varies over time. A higher standard deviation means higher volatility.
To find the standard deviation, you need to do the following:
- Calculate the data set average (i.e., the Sum of all the values/the number of values.)
- Calculate the deviation from the mean (i.e., Each Data Value – the mean)
- Add up all the squared deviations (this gives the sum of squares)
- Divide the sum of squares by the number of values (if you have the whole population) or by one less than the number of values (if you have a sample).
To get the standard deviation, you need to find the square root of the result. For example, suppose you have a data set of 5, 7, 3, and 7. Then:
The mean is (5 + 7 + 3 + 7) / 4 = 5.5
The deviations are (5 – 5.5), (7 – 5.5), (3 – 5.5), and (7 – 5.5), which are -0.5, 1.5, -2.5, and 1.5
The squared deviations are (-0.5)^2, (1.5)^2, (-2.5)^2, and (1.5)^2, which are 0.25, 2.25, 6.25, and 2.25
The sum of squares is 0.25 + 2.25 + 6.25 + 2.25 = 11
If we assume this is a sample, we divide by one less than the number of values, which is 4 – 1 = 3
The result is 11 / 3 = 3.67
The standard deviation is √3.67 = 1.92%
To annualize the volatility, you multiply the daily volatility by the square root of the number of trading days in a year (say 252).
Annualized volatility = Daily volatility x √252
= 1.92% x √252
=1.92% x 15.87
Annualized volatility = 30.47%. It means the asset has a 30.47% chance of deviating from its average return over a year.
Types of Market Volatility
Imagine you are on a roller coaster ride. The roller coaster represents the market, and the height of the track represents the price of an asset or a security. The speed of the roller coaster means the volatility of the market. There are different types of market volatility that you can experience on this ride, such as:
- Low volatility: It is when the roller coaster moves slowly and smoothly, with minor ups and downs. The price of the asset or security changes slightly over time, and there is little uncertainty or risk involved. You feel calm and relaxed on this ride but also a bit bored.
In this case, the market volatility is less than 20%, and returns are stable but low.
- Medium volatility: This is when the roller coaster moves faster and more erratically, with moderate ups and downs. The price of the asset or security changes moderately over time, and some uncertainty or risk is involved. You feel excited and nervous on this ride but also a bit challenged.
In this case, the market volatility ranges between 20 – 40%, and it does not indicate to the investor whether to stay invested or quit.
- High volatility: It is when the roller coaster moves quickly and wildly, with large ups and downs. The price of the asset or security changes significantly over time, and there is a lot of uncertainty or risk involved. You feel thrilled and scared on this ride but also overwhelmed.
In this case, the market volatility is above 40%, and it is mostly a signal to shrewd investors to look for an entry in the bourses when prices plunge and exit as prices soar. Depending on your personality and preferences, you may enjoy different types of market volatility on your roller coaster ride. Some investors prefer low-volatile stocks because they value stability and predictability.
Some investors prefer medium volatile stocks because they seek growth and opportunity. Some investors prefer highly volatile stocks because they crave adventure and reward. However, no matter what type of market volatility you prefer, you should always wear your seat belt and follow the safety rules.
Factors Affecting Stock Market Volatility
Numerous factors influence market volatility. To stay focused and to keep it simple enough, we have covered only the important ones here –
- Economic Factors
One of the most important factors that affect market volatility is the state of the economy. Economic indicators, such as gross domestic product (GDP), inflation, interest rates, unemployment, consumer confidence, and business sentiment, can significantly impact the demand and supply of various assets in the market.
When the economy grows, more investors want to enter the markets adding to the market volatility and asset prices. Conversely, in a sinking economy, more investors quit the markets, creating instability and imbalance in market volatility.
- Political Factors
When political stability and uncertainty exist in a country or region, investors tend to be more confident and optimistic about its economic prospects and policies. This, in turn, increases the demand and price of its assets and decreases its market volatility.
Conversely, when political instability and uncertainty exists in a country or region, investors tend to be more fearful and pessimistic about its economic prospects and policies, which can decrease the demand and price of its assets and increase their volatility.
- Market Factors
Market dynamics, such as supply and demand, liquidity, trading volume, market depth, market breadth, market structure, and market participants, can significantly impact the price movements of different assets in the market.
For example, when there is an excess supply or a shortage of demand for an asset in the market, its price tends to fall, and its volatility tends to rise. Conversely, when there is an excess demand or a supply shortage for an asset in the market, its price rises, and its volatility falls.
- Other Factors
These factors are not directly related to the economy, politics, or market but can still affect the price and volatility of different assets in the market. These factors include Company’s performance, global economic policies, and geopolitical events, that affect different markets in different ways.
For example, when a company reports higher-than-expected earnings or announces a merger with another company, its stock price may rise, and its volatility may decrease. Conversely, when a company reports fraud or a lawsuit, its stock price may fall, and its volatility may increase.
How Can You Cope Up With Market Volatility?
Market volatility is unavoidable, so follow these steps to cope with it in the best possible way-
- Understand your risk tolerance and return objectives
You should know your risk capacity and what returns you expect to achieve. This will help you choose the appropriate level of volatility for your portfolio and avoid taking too much or too little risk.
- Have a clear and consistent investment strategy
A clear and consistent investment strategy helps you plan and stick to your goals. You can stay emotionally balanced and avoid making impulsive or emotional decisions based on market volatility.
- Build a Well-Diversified Portfolio
You should not only diversify your portfolio across different asset classes (such as stocks, bonds, and commodities) and sectors (such as technology and health care), but also regions (such as the US and Europe) and strategies (such as value and growth).
This will help you reduce your risk concentration to any single source of risk or volatility and balance your portfolio performance in different market conditions.
- Monitor your portfolio performance and adjust accordingly
You should monitor their portfolio performance and adjust accordingly based on their risk tolerance, return objectives, and market conditions. This can help you to maintain your desired level of volatility. You can also take advantage of market opportunities or avoid market pitfalls.
Investors should not avoid market volatility altogether, as it offers opportunities to buy undervalued stocks or sell overvalued ones. However, they should also not chase volatility blindly, as it can expose them to unnecessary losses or emotional stress. Instead, they should aim for optimal volatility, which can help them achieve consistent and satisfactory returns over time.
Market volatility can help boost equity returns for investors willing to take some calculated risks and have a sound investment strategy. However, volatility can also be a source of loss or stress for investors who are not prepared or informed enough to deal with market fluctuations. Therefore, investors should research and analyze before investing in volatile stocks.
What are the causes and effects of market volatility?
Market volatility is influenced by various factors, such as economic, political, market, company-specific, psychological, and global factors. It can positively and negatively affect investors, depending on their investing goals, strategies, and preferences.
How can investors reduce the impact of market volatility on their portfolios?
Investors can reduce the impact of market volatility on their portfolios by using various techniques, such as diversification, asset allocation, hedging, and risk management. These strategies can help you avoid excessive exposure or damage from market volatility.