Volatility refers to the frequency and degree with which the price of a security fluctuates. It can drive inexperienced investors to make irrational trading decisions, but savvy investors can profit from it.
Learn how volatility works and how to assess the volatility of individual securities to make smarter investing choices.
What Is Volatility?
Volatility in investing refers to up or down movements in the price of a stock, bond, mutual fund, or other security over time. Investment analysts typically measure the volatility of a security through a "beta" value, which 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 also refers to fluctuations in the overall stock market. In an economic sense, it refers to price swings in general.
- Alternate name: Stock volatility
How Volatility Works
Whenever you invest in securities, you undertake risk, and one of the main risks of investing is volatility. All securities are subject to price fluctuations, either up or down, that occur on an annual, monthly, or even daily basis. Such fluctuations may stem from the actions of a company, such as the release of a poor-quality product. Other times, they result from market or economic shifts, governmental decisions, or global events. Generally, an investor has no direct control over the shifts that cause volatility.
That being said, not all securities have equal volatility. For example, stocks as a whole have the potential to yield higher returns than bonds, but they're also more volatile, making them riskier in the short term. Bonds produce moderate returns but 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, investors 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.
When evaluating the beta of a security, remember that the higher the beta value, the more volatile a security is. The beta has a base value of 1, which corresponds with the volatility of a benchmark index like the S&P 500 and indicates that a security has 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 every 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 every 1% the benchmark index moves.
The higher the beta value of a security, the more volatile it is.
Stocks have generally 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. Historically, 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 were associated with periods of increased volatility in stock prices in general. Black Monday caused the Dow Jones Industrial Average (DJIA) to drop by 22.6% on October 19, but it recovered 57% of that decline within two trading sessions.
More recently, 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 coronavirus 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, that doesn't mean the security isn't worth investing in. On the flip side, a stock with a beta value under 1 won't necessarily make a smart addition to your portfolio. As some volatility is inescapable, the key to investing amidst volatility is to use it to your advantage.
There are several ways to do so:
- Weigh risks against rewards: Determine your investment objective, time horizon, and risk tolerance. Stocks, for example, are generally more volatile than others but carry the potential for greater returns. You may be willing to accept that volatility if more aggressive investment growth is your goal, and you're willing to potentially lose 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 consider securities with below-average volatility.
If you're going to invest in a more volatile security, such as stock, it should also carry the potential for greater rewards to make that risk worth taking. Looking at historical returns of a particular security is one way to predict how it might fare in the future, though there's no guarantee 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 minimize the decrease in the overall value of your portfolio if stocks were to take a hit. Likewise, invest in companies in different sectors to soften the blow to your portfolio if one sector were to decline.
- Stick to your strategy: Inexperienced investors pay attention to what other people are doing on a day-by-day or even minute-by-minute basis, selling as their shares fall and buying as they rise. But this strategy is often a recipe for disaster. Experienced investors stick to their investment strategy amidst periods of volatility.
- Invest over the long term: If your financial situation supports it, consider extending your investing time horizon. Volatility is most impactful in the short term, but many of the same securities that took a dive in price during a market downturn will rebound eventually.
- Use dollar-cost averaging: For long-term investors regularly putting away money through a dollar-cost averaging plan, volatility is not particularly meaningful. The regular contributions can help even out the average price paid, over the course of many years.
- Make money from volatility: 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 people may be willing to pay more for derivatives like put options.
- Volatility in investing is the frequency and degree of fluctuation in the price of a security.
- The more volatile a security is, the more likely it is to go up or down in value in the short term.
- A common measurement of volatility is the beta value, which has a base of 1 that correlates with average volatility. The higher the value, the more volatile the security.
- You can't altogether avoid volatility, but portfolio diversification and other investment strategies allow you to use it to your advantage.