Volatility refers to the frequency and degree with which the price of a security fluctuates. It can drive newer investors to make hasty or irrational trading choices, but savvy investors can profit from it.
Learn how volatility works and how to assess the volatility of many types of securities to make smarter choices when you invest.
What Is Volatility?
Volatility in investing refers to up or down shifts in the price of a stock, bond, mutual fund, or other security over time. Investment analysts most often measure the volatility of a security through a "beta" value. This metric compares the fluctuations of a security to those of a benchmark index, like the S&P 500. The more volatile a security is, the greater the potential it has to lose or gain value in the short term.
- Alternate definition: Volatility can also refer to shifts in the stock market as a whole. In an economic sense, it refers to price swings in general.
- Alternate name: Stock volatility
How Volatility Works
If you invest in securities, there's no way around that fact that you'll be taking on some degree of risk. One of the main risks of investing is volatility. All securities are subject to price changes, either up or down, and these can occur on an annual, monthly, or even daily basis. Such shifts may stem from the actions of a company, such as the release of a sub-par product. Other times, they result from larger forces like market or economic shifts, governmental decisions, or global events. Most of the time, you won't have any direct control over the shifts that cause volatility.
Are Some Asset Classes More Volatile Than Others?
That being said, not all securities are the same when it comes to volatility. For example, stocks as a whole have the potential to yield higher returns than bonds, but they're also more volatile, making them more risky in the short term. Bonds produce slow and steady returns, but they come with less volatility and risk.
But this doesn't mean that stocks across the board are more volatile than bonds. For example, high-yield "junk" bonds come with more volatility. Rather than assess the volatility of a security based on its asset class (stocks or bonds, for example) alone, you can also look at the beta value of a security. Stock-tracking services publish the beta values of securities, though you can also ask your broker to supply them.
How Can I Measure Volatility?
When you assess the beta of a security, take note that the higher the beta value, the more volatile a security is. Beta values correspond with benchmark indexes, like the S&P 500. The beta metric has a base value of 1. A security with a beta value of 1 would fall right in the middle, or have the average volatility for all securities. Securities with a beta of over 1, then, have above average volatility, whereas those with a beta below 1 have below average volatility.
A security with a beta of 1 moves up or down by 1% for each 1% the benchmark index moves. For example, let's say that you buy a stock with a beta value of 1.50. The stock price is liable to move up or down by 1.50% for each 1% the benchmark index moves.
The higher the beta value of a security, the more volatile it is.
For the most part, stocks have rewarded long-term investors with strong positive returns over time. But the stocks of large firms have lost value once every three years on average. There are a number of past events including the Great Depression of the 1920s and 1930s, the oil shock of the 1970s, and the infamous "Black Monday" stock market crash of 1987 that were linked to spans of increased volatility in stock prices in the market overall. Black Monday caused the Dow Jones Industrial Average (DJIA) to drop by 22.6% on October 19, 1987, but it gained back 57% of that decline within two trading sessions.
In more recent times, the financial crisis of 2008 produced a drop of nearly 7% in the DJIA on September 29. But that figure was surpassed when the COVID-19 pandemic hit the U.S., causing the DJIA to drop by 12.9% on March 16, 2020.
How to Manage Volatility In Your Portfolio
Just because the beta value of a security is above 1, doesn't mean it isn't worth investing in. On the flip side, just because a stock has a beta value under 1, doesn't mean it will make for a smart purchase by default either. You won't be able to escape some degree of volatility, and so when change is a given, the key is to accept it, plan for it, and make it work in your favor.
There are many ways to do so:
- Weigh risks against rewards: Figure out your goals, time horizon, and risk tolerance. Stocks, for example, tend to be more volatile than other assets, but could lead to greater returns. You might be willing to accept that risk if more aggressive growth is your goal, and if you're willing to lose some money in the short term to reap greater returns in the long term. But if you have neither the time horizon nor the risk tolerance to endure losses, you may want to stick to assets with lower volatility.
If you plan to invest in a more volatile asset, such as stock, the risk should be worth taking. Looking at past returns of a given asset is one way to predict how it might fare in the future, though there's no promise that past returns will translate into future returns.
- Maintain a diversified portfolio: Strive for diversification both in the asset classes and the individual securities you include in your portfolio to curb the impact of volatility. For example, having bonds can temper the decrease in the overall value of your portfolio if stocks were to take a hit. Also, it's wise to invest in companies in a number of sectors to soften the blow to your portfolio if one sector were to decline.
- Stick to your strategy: New investors tend to watch what other people are doing on a daily basis, or even minute by minute, selling as their shares fall and buying as they rise. But this method is often a recipe for disaster. Savvy investors know to stick to their strategy, even amidst times of great change.
- Invest over the long term: If your financial situation supports it, you may want to think about extending your time horizon. Volatility has the most impact in the short term, but many of the same securities that took a dive in price during a market downturn will rebound over time.
- Use dollar-cost averaging: For long-term investors who put away money through a dollar-cost averaging plan on a regular basis, volatility is not much of a concern. The steady contributions can help even out the average price paid, over the course of many years.
- Make money by going against the grain: Value investors, for example, seek to buy assets when no one else wants them. And certain types of options traders may make much higher profits when fear is rampant because in such times people may be willing to pay more for derivatives like put options.
- Volatility is a way to describe how often and by how much the price of a security changes in the market.
- The more volatile a security is, the more likely it is to go up or down in value in the short term.
- A common way to measure volatility is the beta value, which has a base of 1. The higher the value, the more volatile the security will be.
- You can't fully avoid volatility, but there are many methods you can apply to make it work in your favor, or at the very least curb risk.