Published - November 22, 2022 @ 1:00 PM (EET)
Market volatility is a statistical measure of price movements for a specific market or security index.
In the securities markets, volatility is often associated with big swings in either direction, up or down and the bigger and more frequent the price swings, the more volatile the market is said to be.
Though leading stock indices like the S&P 500 gain or lose less than 1% a day, sometimes the market experiences significant price changes, which professional investors generally refer to as volatility.
Economic uncertainty typically causes stock market volatility and is influenced by interest rate changes, inflation rates, and other monetary policies, but is also affected by industry changes and national or global events.
For example, during the beginning of the COVID-19 pandemic, indices routinely rose and fell by more than 5%, which led to uncertain investors frantically buying and selling.
How Is Market Volatility Measured?
There are several ways to measure volatility, including beta coefficients, option pricing models, and standard deviations of returns.
Statistically, standard deviation allows you to see how much something differs from an average value and provides a framework for the odds that it will happen.
Simply put, “the higher the standard deviation, the more that portfolio is going to move around, up or down from the average,” says Brad Lineberger, CFP, president and founder of Seaside Wealth Management in Carlsbad, California.
You can also measure the variation of an asset by quantifying its daily return (daily percentage moves) and be seen through the VIX or Volatility Index.
Created by the Chicago Board Options Exchange, the VIX, often referred to as the "fear gauge," is based on future bets investors and traders are making on the direction of the markets or individual securities.
An Investment Opportunity
Though heightened volatility could signal trouble, it may be one of the keys to successful investing as it offers investors the opportunity to buy additional stocks in companies at lower prices.
For instance, in 2020, during the bear market, you could buy shares of an S&P 500 index fund for roughly a third of the price from the month prior after more than a decade of consistent growth.
When markets eventually rebound, your investments would have been up roughly 65% from their low and 14% from the beginning of 2022.
Similarly, investors can take advantage when a stock rises quickly by selling out and investing the proceeds in areas that represent better prospects.
The Bottom Line
Historically, although unsettling, market volatility is not unusual and often corrects after three downward waves.
If you built an appropriately diversified portfolio, you could rebalance your portfolio to bring it back in line with your investing goals and match the level of risk you want.
More importantly, investors who resist the urge to sell and exit the market early will witness the best recovery days and most attractive buying opportunities, which can significantly impact longer-term returns.
Lastly, to limit your risk during market volatility, the best thing you can do is to get educated.
