Investment strategy What is market volatility?

What is volatility?

Volatility is a term used to describe the degree of variation or fluctuation in the price of a financial instrument – such as a stock, bond or currency – over a specific period. Essentially, it measures the amount of uncertainty or risk associated with an investment.

In other words, volatility refers to the speed and magnitude of changes in an asset's value. When a stock price is highly volatile, it means that the stock is experiencing significant price swings, either up or down, in a short time frame. On the other hand, low volatility means that the stock is experiencing minor fluctuations in price.

While market volatility can be unsettling for some investors, it is a natural part of investing and can present opportunities. Understanding what causes volatility and how to manage it is crucial for investors looking to navigate the financial markets. In the next sections, we'll explore how volatility affects investors, how it is measured and how to manage it.

How volatility can affect investors

Volatility can have a significant impact on investors, affecting their investment strategies, returns and emotions. Here are some of the ways in which volatility can affect investors:

• Risk tolerance: Volatility can affect an investor's risk tolerance, or their willingness to take on risk in pursuit of potential returns. During periods of high volatility, some investors may become more risk-averse, while others may see it as an opportunity to add additional risk.
• Investment strategy: Volatility can affect an investor's strategy, as they may need to adjust their portfolio or time horizon in response to market fluctuations.
• Returns: Volatility can have an impact on an investor's returns, as market fluctuations can lead to significant gains or losses in a short amount of time. Investors who have a longer-term investment horizon may be better equipped to weather these fluctuations and benefit from potential long-term gains.
• Emotions: Volatility can also influence an investor's emotions, leading to fear, anxiety or panic. These emotions can cause investors to make rash decisions or panic sell their investments, potentially resulting in significant losses.

Managing volatility

While market volatility can be unsettling, it is a natural part of investing, and investors can take steps to manage it. Here are a few strategies for managing volatility:

• Diversification: One of the most effective ways to manage volatility is through diversification. By investing in a range of assets across different asset classes, sectors and geographic regions, investors can spread their risk and reduce the impact of volatility on their portfolio. A common way to achieve diversification is through investing in a mix of stocks, bonds, real estate and other asset classes.
• Rebalancing: Rebalancing is the process of periodically adjusting the allocation of assets in a portfolio to maintain a desired level of risk. This involves selling assets that have performed well and buying assets that have underperformed to bring the portfolio back to its original allocation. Rebalancing can help to manage your risk tolerance and manage volatility. However, selling appreciated investments could have tax consequences so you need to factor that in and speak to your tax professional.

Asset allocation/diversification does not guarantee a profit or protect against a loss.

Measuring volatility

In order to manage a portfolio, it may be helpful to measure and calculate volatility. There are different methods of measuring the level of volatility in the market. Two of the most common ways of measuring volatility are by calculating standard deviation and by using the CBOE Volatility Index (VIX).

Calculating volatility

One way to measure volatility is by determining the standard deviation of a financial instrument’s returns over a particular period. Standard deviation is a statistical measure that indicates the degree to which an asset’s price deviates from its average price. A higher standard deviation indicates that the asset’s price has experienced more significant fluctuations.¹

Volatility Index (VIX)

Another way to measure market volatility is through the CBOE Volatility Index (VIX). The VIX is a measure of the market's expectation of volatility over the next 30 days. It is often referred to as the "fear index" because it tends to rise when investors are fearful and fall when investors are confident.²

The VIX is calculated using the prices of options contracts on the S&P 500 index. Options are financial instruments that allow traders to buy or sell a stock at a specific price at a specific time in the future. By looking at the prices of options contracts, traders can gauge market sentiment and expectations for future volatility.³

Bottom line

As you develop an investment strategy, it’s important to keep in mind that you will encounter volatility along the path to your financial goals. Speaking with a financial advisor could be one way to plan for – and perhaps even benefit from – the inevitable fluctuations in the market.