Volatility in the stock market is arguably one of the most misunderstood concepts in investing world. It can drive the new and novice investors to question their own investment strategies due to short-term fear. So, from an investor’s point of view volatility in the stock market is an important concept.
In this article
- What is volatility in the stock market?
- Why investors should care about volatility in the stock market?
- Causes of volatility in the stock market
- How to beat volatility in the stock market?
- How do we measure market volatility?
- The Bottom Line
What is volatility in the stock market?
Volatility is the range (highest to lowest) of price change a stock experiences over a given period of time. If the stock’s price stays relatively stable, then it has low volatility. And a highly volatile stock is one that hits new highs and lows, moves erratically, and experiences rapid increases and dramatic falls in the stock market. Highly volatile stocks, that move by larger margins can be more profitable on the upside but also carry a greater risk of loss. Thus, volatility is a measure of risk in the stock market.
Why investors should care about volatility in the stock market?
- Volatility in the stock market can define position sizing in the investment portfolio.
- Volatility in the stock market presents opportunities to buy stocks cheaply and sell when overpriced.
- There is a strong relationship between volatility and market performance. When volatility tends to decline as the stock market rises and increase as the stock market falls.
- When volatility increases, the risk increases too.
- Volatility in the stock market comes and goes. It may rise suddenly but could take a long time to come back down again.
Causes of volatility in the stock market
Over the past decade in the Indian stock market, we have seen the crash of 2007-08 all the way to new record highs for stocks in 2018. And there have been a lot of ups and downs in between. Often, the stock market is volatile when something unexpected happens. Here are the most common causes of what can lead to a volatile stock market.
1. Political developments
It is easy to see why politics play a big factor in the movement of the stock market. After all, the elected government plays a major role in regulating industries and impacts the economy overall when it makes decisions on things like new policies, laws, taxes, tariffs, trade agreements, federal spending etc. Everything from speeches to legislation to elections could cause knee-jerk reactions among investors in the stock market.
2. Economic indicators
Economic data of any country offers a window into the health of its overall economy. When the economic indicators are doing well and achieve set targets, the market tends to react positively. And when the set targets are missed, the markets may tumble. This is why economic reports are often awaited with bated breath by investors in the stock market.
3. Performance and the public relations of big companies
Sometimes volatility is not market-wide, rather an individual company can see its stock performance take a hit or climb. And depending on how large is the company, its performance can have a greater effect on the stock markets.
4. Volatility in the overseas market
The modern economy is more globally connected than ever. It means that what happens in the world has a major impact on what happens at a domestic level. War, a political coup, regime changes and the like have high potential to impact trade, Multi-National Corporations (MNCs) and the flow of money along with investments between countries. So, when there is even a little hint that something might be going to happen at the international level, it can cause markets to swing at a domestic level.
5. Market correction
When the stock market has been performing exceedingly well for a long time, chances are the stocks are overvalued – it needs correction and settles down around stable value. A market correction refers to a price decline of at least 10% of any stock or market index following a temporary upswing in market prices.
How to beat volatility in the stock market?
Here are few strategies to help you beat volatility in the stock market.
1. Ignore Short-Term chaos in the stock market
One of the common methods used in times of market volatility is to stay the course despite the current overreaction of the stock market. Even though this may seem to be a lazy and counterproductive strategy, it may insulate you from losses associated with attempting to time the stock market. Virtually, it is impossible to time the stock market top to determine when to get out, and just as difficult to discern the bottom of the market and when to get back in and invest again.
2. Purchase additional stocks
Volatility in the stock market can also create opportunities for an astute investor to use it to their own advantage. It can provide entry points for those investors whose time horizon of investment is long-term. Downward market volatility brings in investors who are bullish and believe that the stock market will perform well in the long-run with the opportunity to purchase additional stocks at lower prices. Increasing your position portfolio at a discounted price can be a very powerful investment strategy. This thinking must be also in line with your risk tolerance and overall financial goals.
3. Don’t stop investing
Have a plan in place outlining your financial goals and time horizon before you need it and review it regularly to ensure it serves you well during all types of market conditions. This will help you navigate through periods of volatilities when many people are panicking or acting out of fear.
Always diversify your investment portfolio, do not just put all your eggs in a single basket. Being diversified is one of the best ways to help manage your exposure to the volatility in the stock market. By spreading your money out over various asset classes, you are also spreading out your risk from market conditions, and ensuring your portfolio’s results are not based on the performance of one type of investment instrument.
How do we measure market volatility?
The following 2 parameters help you assess the market volatility: 1. Standard Deviation The primary measure of market volatility used by stock investors and analysts is the standard deviation. This reflects the average amount a stock’s price has differed from the mean over a given period of time. It is calculated by determining the mean price for the particular period and then subtracting this figure from each price point. The differences are then squared, summed and averaged to produce the variance. After that standard deviation is calculated by taking the square root of the variance. Mathematically it is shown as: Mean value = Sum of all price values / Total number of price values Variance = (Sum of all (Each price value – Mean Value)^2) / (Total number of price values -1) Standard Deviation = Square root of (Variance) A higher value of standard deviation depicts higher market volatility.
Beta is a commonly quoted measure of the relative volatility of a particular stock in the stock market. Beta value for any stock tells the investor the correlation of the stock’s price to its benchmark index. For example, If a stock is having a beta of 1.2, that means, historically that stock moved 120% for every 100% of the Index move. So, a stock having a high beta value will deviate from its benchmark index mean more than a stock with a low beta value.
The Bottom Line
It is very crucial for investors to understand that volatility in the stock market is inevitable, and attempting to navigate around it is a very risky game. The stock markets tend to move up and down in the short-term and volatility should not be the deciding factor as to whether or not investors should immediately exit. With a strong understanding of volatility, its causes and how to beat it, investors potentially can take advantage of the opportunities resulting from the volatile stock market. Happy Investing! Disclaimer: the views expressed here are of the author and do not reflect those of Groww.