Volatility in the stock market refers to the possibility of a shift in a security’s value. It is a statistical measure that signifies the variation in returns for a security or market index.
A stock market with more than 1% of rise or fall over a sustained period is a volatile market. Before investing, therefore, it is important to consider the volatility index of an asset.
Securities with high volatility carry significantly greater risk for investors than their low-volatility counterparts. Greater volatility also means a substantial possibility of earning big figures in a short investment duration.
Understanding Volatility and Its Causes
Stock markets become volatile during events of uncertainty. It is not common for market indices to rise or fall by even 1% during a single day. However, the beginning of covid saw index variations of up to 5% every day.
There are several reasons for volatility in the stock market or some particular security. We can list some of them:
- International events (wars, pandemics, natural disasters etc.)
- Supply chain disruptions
- Inflation triggered events (Bank of Canada adjusting the interest rate)
- Changing government policies (taxes, spending priorities etc.)
- Lawsuits and media controversies
- Regulatory actions (Canadian Securities Administrator (CSA) regulating local securities)
- Sector-specific developments (e.g. tech sector facing chip shortage)
- Levels of corporate earnings
The high volatility during the days of uncertainty may result from buying and selling frantically when no one is aware of the result and how the situation and value of an asset will change.
Additionally, stocks tend to become more volatile during certain defining moments in the market. For example, around the time when the earning reports are revealed, etc.
Assets or securities with higher volatility can offer investors a wide range of potential values. This means that the returns can greatly increase or decrease over a short duration. While assets with lower volatility do not vary dramatically in value.
Nevertheless, high volatility is almost exclusively associated with fear. This can happen during bear markets (when markets crash by more than 20%), stock market crashes, etc.
There is also historical volatility. This is based on the historical performance of a security in terms of prices and gives an insight into the degree of variability in a security’s return. Companies with a well-capitalized and established reputation often do not exhibit high volatility for their shares.
The best advice for investors who experience extreme market volatility
If you are a young investor, you probably have a long road of investments to go down before you think about retiring. You can probably afford to invest for longer durations spanning years.
Investing involves risk and requires one to continuously gauge the market environment. If you are not looking to liquidate your assets immediately and are willing to wait for your shares to rise in value over a long period of time, you will probably experience much greater returns in the long term, even when the volatility of your stocks causes the values to go down temporarily.
For this reason, young investors are less averse to the risks of investing in volatile markets. On the other hand, investors who are nearing retirement must remain more risk-averse and invest in stocks that can liquidate easily and guarantee monthly or quarterly dividends.
Investors must check out the stock indices for diversification to balance out individual stock volatility. At the sector level, investment in ETFs (exchange-traded funds) is another way to maintain diversification.
Here’s What You Must Do to Handle Volatility
Here are some of the tried and tested ways to handle market volatility in the best way possible.
1. Do not sell based on short-term indicators.
It is common for novice investors to sell stocks when the markets dip. Revisit your investment strategy here. History has proven repeatedly that waiting out the course is always better than selling out the stocks when the prices are at their lowest. Instead of being swayed by short-term fear, understand the role of the stock in your portfolio and its long-term implications. Only then must you decide whether to sell out or retain the stock.
2. Consider Your Financial and Emotional Ability to Tolerate Risk
Your ability to handle dips financially is called risk capacity. Risk tolerance is your ability to handle the emotional consequences of experiencing big price swings.
You should consider ways to invest money with significantly fewer risks and greater security. For example, retirees must have at least 12 months of living expenses in their bank accounts or money market funds. They must have additional years’ worth in bonds that can liquidate or mature in times of need.
3. Invest in other Stable Assets
You can also invest in other stable assets, such as Certificates of Deposits (CDs) or Treasury Bonds. Another way to go is to buy insured investments. These are investments that often have attached guarantees, provide creditor protection and allow you to bypass probate by naming beneficiaries.
Perform proper financial research of the historical prices to estimate the future performance of your securities.
4. Maintain a Diversified Portfolio
If you’re greatly affected by market volatility, your portfolio is probably not as diversified as you thought. You must be thoroughly acquainted with what each of your assets is doing to your portfolio and if they are collectively matching your target asset allocation.
Portfolio diversification brings more stability when it comes to your returns. Try to counter short-term market dips by including defensive assets, such as bonds, cash, and cash equivalents.
For investors hoping to spend money in the short term, it is best to invest in assets that have historically exhibited low volatility and high liquidity.
5. Rebalance Your Portfolio
When market prices change, it skews the balance of your portfolio and asset allocation. By rebalancing your portfolio, you sell positions that have become overweight compared with the rest of your portfolio and move proceeds to underweight positions.
This type of balancing resolves the problem of overexposing your portfolio to undesirable risks, which appear when your portfolio skews away from your target allocation.
6. Adapt to Fast-Moving Markets
The first and last hours of the trading session are typically the most volatile, so be careful when trading during those hours.
Always take current conditions into account and scale in or out of positions by buying or selling incrementally during hours of fluctuations.
A Final Word
While investing involves risk and it is difficult to hold your own during difficult volatility hours, the best advice we can give investors, especially those willing to wait for a long time, is to hold tight and continually assess their risk tolerance. Inflation can erode the worth of savings quite fast. The right portfolio of investments in the stock market or other instruments can act as a hedge against inflation, giving you the much needed financial cushion.