How is stock market volatility defined and managed?
Day in and day out, the stock market rises, stalls, or falls. The equity market is dynamic and change is in its very nature. A small amount of change is natural and expected. However, sometimes, there is a significant change in price levels, and this is called ‘volatility’. A high level of current market volatility can potentially be a troublesome sign, but it is inevitable if you want to become a long-term investor.
In this article, we will examine market volatility, how it is measured, and how a smart investor should handle it.
Market volatility - Definition
Market volatility refers to how often or how much the prices fluctuate. This could apply to either a rise or a fall in price. Volatility captures magnitude and frequency. The higher the change in the market prices, the higher the current market volatility. Volatility in the market is normal and should be expected and accounted for.
How is current market volatility measured?
Standard deviation is an excellent measure of how much certain values differ from a given average. Current market volatility can be measured by calculating the standard deviation of the changes in price over a given period. A higher value of standard deviation is indicative of bigger changes in the value of a portfolio. Standard deviations indicate the range of potential value changes and the likelihood of these changes occurring. Typically, 68% of values fall within one standard deviation from the mean, 95% fall within two standard deviations, and 99.7% fall within three.
Traders who invest in the stock market can determine standard deviations using end-of-day prices, intraday price movements, or anticipated future price changes. Most casual market investors can recognise the latter method, utilised by the Chicago Board Options Exchange’s Volatility Index, or VIX.
What is VIX?
In terms of current market volatility, VIX is also called the ‘fear index’. It is a popular method to measure market volatility as it tries to understand the expectations of investors concerning the price change in S&P 500 stocks over the next 30 days.
As a general rule, a higher VIX indicates more expensive options. Usually, the VIX stays around 20, suggesting that the S&P 500’s value will not vary more than 20% from its average. But in the last ten years, the VIX has generally been lower, indicating less expected market fluctuation.
What level of current market volatility is normal?
Markets experience volatility constantly, with around 15% fluctuation from average annual returns. Usually, the stock market remains stable, with occasional brief periods of high volatility. In general, it has been observed that bullish markets have low current market volatility, while bearish markets are more unpredictable, with frequent price swings, usually downward.
How to mitigate current market volatility?
When trading shares, there can be numerous ways to mitigate the current market volatility. Despite the wide variety of options, none of the professionals recommend panic selling in reaction to a big fall.
In times of current market volatility, you can utilise the following strategies:
Stick to long-term plans
Investing should be a long-term game. If you believe you may need funds in the near future, that money should never be invested. A diversified and balanced portfolio is built for the long term and accounts for brief periods of volatility. Market turbulence is very much a part of the game and a test of your patience and belief in your analysis. Remember, patience in the long term is invaluable in generating returns.
Perceive volatility as an opportunity
While market turbulence can reduce the value of your portfolio, it also brings with it a golden opportunity to purchase some stocks that had earlier been performing very strongly.
For instance, during the bearish market trend of 2020, at one point, shares of the S&P 500 index could be bought at 30% of their value just a month prior as this fall came after almost 10 years of steady and continuous growth. Such opportunities to enter the market could only be recognised when you can view volatility as an opportunity. Your existing portfolio's value might fall, but the gains from a timely entry could easily offset it.
Save up for emergencies
A downward spiral in prices is usually not an issue for an investor unless the invested funds need to be liquidated. This forms the bedrock of why a smart investor always saves up for emergencies and has secured funds that can be used towards living expenses for approximately half a year.
Also read: Share market timings
Portfolio management
Current market volatility can derail your portfolio’s asset allocation from its target. During such times, you should rebalance your portfolio to align with your investment goals and desired risk level. It is recommended that you sell assets that have grown too large and buy those that have decreased. A good rule is to rebalance if allocations drift by more than 5% or an asset class deviates by over 20%.
Bottom line
Understanding and managing current market volatility is crucial for long-term investing. Volatility, measured by standard deviation and reflected in the VIX, takes into account the frequency and magnitude of price changes. Investors should embrace volatility as part of the investment journey, use it as an opportunity to rebalance portfolios, and capitalise on market downturns while maintaining a safety net for emergencies.
