If you watched the stock market over the past few years, you probably noticed that during some periods trended upward. As you look closer, though, you’ll see several periods where the market has dropped or risen significantly over the course of a few days or weeks. These moments of market volatility are natural and occur regularly in the stock market.
During periods of uncertainty, it’s natural to feel anxious about the performance of your portfolio. Many investors also feel unsure about how they should adjust their investment strategy during these periods. It’s important to understand the causes of market volatility and the ways it is measured so that you can best prepare yourself for these moments of uncertainty.
Table of Contents:
- What is market volatility?
- What causes market volatility?
- How is market volatility measured?
- Historical volatility vs. implied volatility
- Market volatility index
- How do you invest during market volatility?
- Bottom line
TL;DR
- Market volatility refers to the variance of returns on a market index over a given period
- Investors measure market volatility by looking at previous performance of a stock/index or by using a market volatility index, such as the VIX.
- A potential strategy for managing market volatility is to maintain your investments and rebalance your portfolio accordingly. Another potential strategy, where some investors choose to “buy the dip” and take the risk of buying a stock at a lower price.
What is market volatility?
Market volatility refers to rapid changes in a market index, which can cause your portfolio to quickly increase or decrease in value. The bigger these fluctuations, the more volatile the market. In the stock market, if the S&P 500 gains or loses more than 1% in a day, that would be considered pretty volatile.
A highly volatile market is usually unpredictable and the value of assets can rise and fall drastically in a short period of time. Usually, high market volatility is associated with a bear market, or a market that’s trending downward. This often happens during periods of economic stress, like a recession or market contraction.
Low volatility often comes during a bull market, when the market is trending upward. This often happens during periods of economic growth.
What causes market volatility?
Volatility reflects the way that investors feel at a given moment. Increased market volatility is usually caused by economic or policy factors, including changes in other markets, interest rate hikes, and the Fed’s current monetary policy. Political instability and other global events, like a pandemic or a war, can also lead to market volatility. Public Trends can help you track large-scale changes to the market and see which stocks are being bought and sold by other users.
During periods of high market volatility, the federal government may put a market circuit breaker, or trading curb, in place. This freezes trading for a period of time — anywhere from 15 minutes to the rest of the day — so that the market has time to stabilize.
How is market volatility measured?
Volatility is a way of understanding differing returns on an asset or market index. To measure this, we need to know what a standard return is and how far the current moment of volatility differs from that standard. You can do this by looking at the standard deviation, which shows how far something differs from its standard value.
Traders on Wall Street usually calculate the standard deviation using intraday volatility (changes to a stock during a trading day), end-of-day values, or the expected change in value. These calculations form the groundwork for indexes that track the market and investors’ responses.
Historical volatility vs. implied volatility
Volatility can be historical (historical volatility) or forward-looking (implied volatility).
To measure historical volatility, you need to find the standard deviation of the change in prices over a given period. By finding the standard deviation of a certain stock, you can determine how far it will likely move from the average value. You’ll also be able to figure out the odds of that change in value. The higher the standard deviation, the more your portfolio will increase or decrease relative to its average value.
Implied market volatility is determined using option prices in the market. An option is an agreement to buy or sell an underlying security at a pre-set price before a certain expiration date. The price of an option is dependent on the chance of that stock moving in a certain direction. Therefore, volatility is a major component of calculating various option prices.
When looking at implied market volatility, many turn to a volatility index, which uses index options to infer forward-looking market volatility. The most common market volatility index is the Chicago Board Options Exchange’s Volatility index, also known as the VIX or the “fear index.”
Market volatility index
The most common market volatility index is the Chicago Board Options Exchange’s Volatility Index, or the VIX. The VIX is based on S&P 500 index options and looks at market volatility 30 days in the future. Since the VIX represents the projected volatility, it also shows market risk and investor sentiment. Because of this, some refer to the index as the “Fear Index.”
During a market crash, it is common to see the VIX move up in value, showing that the market is volatile and investors are fearful. When the market is growing, it is common to see the VIX decrease because investors are comfortable and the market is stable.
The VIX tends to be in the low 20s, which means that the S&P 500 will most likely be within its normal growth rate 80% of the time. However, since the end of the recession, a long-term bull market has kept the VIX at historically low levels. Moments of major disruption often result in short-term spikes in the VIX—during the first month of the coronavirus pandemic, the VIX shot up to the 80s thanks to a huge wave of anxiety around the state of the market and the economy.
How do you invest during market volatility?
If you’re investing for the long term, you’ll almost certainly experience several moments of market volatility. As a rule of thumb, if you’re investing in the stock market, you should expect volatility of around 15% from your average return in a given year. Every five years, the market will likely drop by upwards of 30% from its average level.
Most investors agree that it’s important to avoid panic selling during periods of heightened volatility. You’ll rarely take a profit on a stock by selling at its lowest point. On the other hand, past performance shows that waiting out a down market may lead to positive results.*
Investing in a bear market can be intimidating, but historical evidence shows that some of investmenting during that time may pay off in the long term. “Buying the dip,” as it’s known among retail investors, can be risky but may also lead to a payoff. For example, if you had bought shares of an S&P 500 ETF during a major market downturn in March 2020, your investment would have grown by more than 50% by the end of 2020. Public’s Top Movers tool can show you the most volatile stocks on a particular day.
Some markets are more volatile than others. Cryptocurrency volatility has been particularly important recently, given the current market conditions. Investing in high-risk markets like crypto requires a high risk tolerance and an ability to withstand market declines. Public’s social investing tools can help you track other trader’s decisions during periods of market instability.
*Past performance does not guarantee future results.
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Dollar-cost averaging
Dollar-cost averaging is a common investment strategy used during moments of market volatility. Dollar-cost averaging simply means committing to investing a set dollar amount on a consistent basis, no matter what the stock price is. This lets you invest consistently and helps you avoid the natural temptation to time the market..
Investors who employ a dollar-cost averaging approach can use market downturns to invest in stocks they want to hold for a long time at a lower price. However, most experts say that you should avoid timing a market bottom. If you use Public’s Crypto Recurring Investing feature, you might consider increasing your scheduled Crypto investment during a down market in order to take advantage of price volatility on your favorite crypto. If you want to use Recurring Investing for stocks, don’t worry — we’re adding that feature soon.
Rebalancing your portfolio
During periods of market volatility, you may need to rebalance your portfolio. That’s because sharp swings in the market may adjust your asset allocation away from your intended ratios. As financial markets shift, you’ll need to buy or sell certain asset classes in order to bring your portfolio back into balance.
Public’s large network of fellow investors can offer support and suggestions. And if you want to keep tabs on the market during periods of market volatility, Public Townhalls let you hear directly from founders and c-suite executives.
Bottom line
Market volatility is a strong indicator of the state of the market and overall investor sentiment. A highly volatile market experiences large swings in value, while a less volatile market experiences smaller swings in value.
Volatile markets can be caused by a variety of outside factors, including world events and political change. Policy changes or interest rate increases from the Federal Reserve and the performance of other markets can also lead to increased volatility.
Regardless of the cause, volatile markets reflect uncertainty from investors. Many investors turn to a market volatility index, like CBOE volatility index (the VIX), to get a gauge for overall market risk. This can help guide your investment decisions in moments of uncertainty.
It’s important to remember that when you invest your money in the stock market, your investments should have a long time horizon. Historically, short-term periods of instability have had little impact on the results of long-term investing decisions. However, investing during a bear market can also have benefits. Investors who take a risk and invest during the bear market, may see a potentially better return if the market recovers.
For investors who want to ride out a period of instability, diversification can help you weather a volatile market because your risk is spread across a wider range of asset classes. Using dollar-cost averaging tools, like Public’s Recurring Investing feature, can help you avoid panic selling. Recurring investing is currently available for crypto investments and will be available for stock purchases soon.
Periods of market instability can be anxiety-inducing for investors. This is especially true for investors on a fixed income or who need immediate access to liquidity. Public’s social investing feed can help you find a community of like-minded investors who can support you during turbulent periods.
Remember, even after intense periods of volatility, the stock market has historically outpaced inflation nearly every year. If you remember your investment objectives and stick to your strategy, you’ll likely be able to survive moments of market volatility.
Frequently asked questions
What can cause market volatility?
Market volatility can be caused by economic events or changes to monetary policy. More recently, political events have also led to volatile markets.
Is market volatility a good thing?
Market volatility is a natural part of investing. In the stock market, maintaining and evaluating your investment strategy throughout these periods of volatility, or increasing your positions when the market is in a downturn, may lead to better long term returns.
How do you calculate market volatility?
Traders use a variety of strategies to calculate market volatility. To understand historical trends, they’ll usually measure the standard deviation of a stock from its average value. Future volatility is calculated using indexes like the VIX, which measures investor sentiment.
What is the difference between a bear market and a bull market?
Bear markets occur when a stock or index falls more than 20% from its recent high. Bull markets happen when a stock or index increases more than 20% from its recent low.
What is the difference between volatility and risk?
Volatility is a measurement of the change in an asset’s price over time. Volatile markets come with higher risk, or a higher possibility that an investment won’t perform as expected.
What is a hedge against market volatility?
A hedge is an investment or strategy that guards against a certain market risk. Investors can hedge against market volatility by diversifying their portfolio or using a volatility index.
What is the relationship between market volatility and market performance?
Market volatility may have a lower impact on long-term portfolio performance. Volatility may increase or decrease market performance in the short term.
What might happen if the market volatility is high?
During periods of high market volatility, your investments may rapidly gain or lose value. It’s not uncommon for investors to feel anxious about their investment decisions during this period. Some experts suggest avoiding panic selling and holding out until the market calms down. As an investor, you should evaluate your personal financial situation to determine if this is the right strategy for you.