It goes without saying that volatility can be crazy-making. In our February Edu-Blog series, I will show you just how normal volatility is and that it is actually healthy for markets. Ever heard the adage, “a little bit of fighting is healthy for a marriage,” it’s the same concept for volatility. Without it, markets would be over-inflated, and the value of companies would skyrocket, potentially reaching a “too big to fail” scenario.
Markets are volatile; those are just the facts. We can experience monumental swings in the market as frequently as daily. Volatility indicates investment risk, but it can actually be an opportunity when it's harnessed.
So, What is Volatility?
In the simplest sense, stock market volatility measures fluctuations in stock prices. Low volatility means small fluctuations, and high volatility means large fluctuations.
To illustrate my point, let’s use the example of your favorite beer. One day you’ll go into a store and see your favorite beer at one price, you buy some, have some friends over, and you run out, so you go back to get more, and the price is higher.
This can leave you scratching your head, wondering why the price rose so quickly. That’s volatility - the rate at which the cost of your beer goes up or down.
How Does Market Performance Affect Volatility?
A study was done last year by Crestmont Research that shows the historical relationship between the performance of the stock market and levels of volatility. They analyzed the average range each day and used it to measure the S&P 500’s volatility.
What they found is really no surprise. Their analysis showed that higher volatility is correlated with a higher probability that the market will decline. On the other hand, their research showed that the lower the volatility the higher the probability the market will rise. Like I said, no surprises there.
While their research may have proven one of the underlying beliefs we all have, we can use this knowledge to align your investments with the associated expected returns.
What Factors Can Affect Volatility?
There are several factors that can create an environment for volatility to rise. Three of the most significant factors are:
- The state of the economy
- Tax rate policy
- Interest rate policy
These factors can be so strong at times that they not only cause volatility in the markets, they can even change the direction of the market. Stating the obvious here but, we just lived through an entire year where volatility changed the direction of the markets several times based on the three factors above. Keep in mind that those aren’t the only three factors!
Some other factors that can cause turbulence are things like inflation, industry, and sector disturbances. For example, what if there was a major weather event in Saudi Arabia which affected the production of oil? This would most likely trigger oil prices to rise on fears of decreased oil production, less gas available at the pump, and a decreased ability to drive. We would see this catastrophic thinking and doomsday behavior create a spike in the price of oil-related stocks.
And folks, that’s the recipe for a little bit of hysteria and a bumpy ride. Seems silly, right? I mean nothing in this world is permanent so why do we keep getting overly emotional about these things and causing the market to display our fears in the form of increased volatility and decreased returns?
Part of the answer, my friends, is that the media drives the markets more than we think. Nothing incites a little riot like the 24-hour news cycle and the mad dash for an inflationary scoop to keep your face on the air. And while the media certainly has a large part in causing turbulence, there are plenty of other factors too, like the ones listed above. I just love to pick on the media, they are so deserving.
The Bottom Line
The increased volatility that is associated with bear markets causes decreased earnings and increased stress as we bite our nails, watching our portfolios decrease in value. The next domino to fall is the rush to rebalancing, when investors shift the weight in their investments to more conservative stocks or bonds. This can also cause a buying frenzy, as investors rush to buy big name stocks at fire-sale prices. As Warren Buffett is famous for saying, “Be fearful when others are greedy and greedy when others are fearful”.
Never fear; there is always a silver lining.
For the rest of the month, I will share the ten reasons that I believe we need to reframe our view on volatility. I call this my “volatility silver linings playbook.” I hope these points shed more light on what volatility actually is and that, while disconcerting, it can also be a positive.
P.S. If you enjoyed what you've read here and found it beneficial, we encourage you to share it with your friends and family. I firmly believe that an educated investor is more confident, which leads to healthier finances and fewer sleepless nights.
Until next time...
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Investing includes risks, including fluctuating prices and loss of principal.