Understanding Market Volatility

The stock market never halts. Every day, the market sees gains and losses. With that said, during settled periods, the S&P has gains and losses that tend to fluctuate far less frequently. Every once in a while, there are enormous price changes in the market, and this is known as volatility.

We all tend to see high volatility as a warning sign, but it is common for this to happen when you are investing over the long term. In some cases, it can lead to great success.

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Definition of Volatility

Simply put, market volatility refers to the magnitude and frequency of movements in the market, whether that is up or down. The larger and more frequent prices change, the more volatile the market is considered to be.

According to Nicole Gopoian Wirick, who is the founder of Prosperity Wealth Strategies, volatility is a normal part of investing and is something that anyone with a portfolio is expected to experience at some point. She mentions the fact that if markets were constantly rising, investing would be simple and everyone would be wealthy.

How Do You Measure Market Volatility?

The best way to measure the volatility of the market is to look for a deviation in prices over a certain period. The statistical concept that is known as standard deviation gives you the opportunity to see how different things are when compared to the average value.

You will be given more insight below on how to calculate it, but note that the larger the standard deviation is, the more likely it is your portfolio will experience fluctuations.

It is essential that you keep an eye on standard deviations since they will offer you much-needed insight about how much the value is expected to change, and give some context on when these changes could be expected. Nearly 70% of the time, values won’t be larger than one standard deviation from the average.

With this being said, why don’t we revisit how standard deviations apply to the volatility of the market. End-of-day trading values, intraday volatility, and projected future changes are all used by traders to tally the standard deviations of market values.

Those who only watch the market on a casual basis are probably most familiar with the method used by the Chicago Board of Options Exchange’s Volatility Index, which is typically called the VIX.

What Is the VIX?

The VIX is the most common way that stock market volatility is measured. Some refer to it as the “fear index.” Investors’ expectations are gauged to determine how stock prices will move over a 30-day span based on S&P 500 options trading. Whether the market is expected to go up or down, the VIX charts will show how much things are expected to change for the coming month.

In most cases, the higher the VIX, the more costly you can expect the options to be. This is true for two reasons: One, a type of option known as a put is an agreement for shares to be sold at a designated price at a specific time. Puts increase in value and become more desirable when it is more likely the S&P 500’s value will decline. If it falls beneath the selling price of their puts, they can look forward to a boost in profits.

As the value of these puts rises, market declines can be expected since the stock market tends to experience drastic changes when trends are not doing well.

Generally, normal levels of VIX average in the low 20s, which means that the market will not differ from the average growth rate by more than 20% in most cases/ I will stress that the VIX has been lower over the last decade.

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“Most likely this was due to the long-term bull market that has occured over the past ten years, which has created the opportunity for complacency among those participating in the market. Freddy Garcia, a CFP in Naperville, Illinois, mentions that when markets are spooking people out it is likely that the VIX will temporarily print in the 40s or 50s because traders will be in a rush to buy protection for their portfolios.” VIX values went as high as 82.69 in March 2020 as economic anxiety about the coronavirus began to set in.

This is likely due to there being a long-term bull market for the past 10 years, and it has made many market participants feel complacent.

How Much Market Volatility Is Normal?

Markets tend to encounter increased volatility on a regular basis. When investing, I would advise you to expect around a 15% volatility during any given year.

Every five years or so, you should expect the market to fall 30% at least once. If you know that you are risk averse and not prepared to handle this, you probably should not be an equity investor.

Typically the stock market is pretty steady, but there are times when you can expect to experience above-average volatility. Stock prices are not bouncing around all of the time. There are actually extended periods when nothing exciting happens, then things will make a huge swing up or down.

Bull markets are usually associated with low volatility and bear markets have unpredictable changes that tend to fall downward. This is one of the basic tenets of investing that you always have to keep in mind. This is true for those who have only dipped their toe in the investing pool as well as those seasoned investors who have been buying and selling stocks over the course of many years.

If you have the time, patience, and stomach to handle all of this, you are likely to beat inflation by nearly three times annually. The best advice I can offer is to embrace volatility and accept it as a normal part of the market.

Handling Market Volatility

There are countless reactions you can have when your portfolio starts bouncing all over the place. One thing you should not do is panic after a drop and sell everything you own.

Since 1970, whenever the market fell by at least 20%, the first year of the recovery process is when the largest gains have been generated. So if you sold everything immediately and tried to buy it back later, you will have missed out on large rebounds and you may never be able to recover the initial value.

Here are some ideas of what to do when the market is being particularly volatile:

Focus On Your Long-Term Plans

Investing is a game that needs to be played in the long haul. if you are someone who wants quick returns, this is not the place for you. Especially since volatility can prevent you from cashing out on demand. Always remember that volatility is part of the journey to enormous growth.

Gage Paul, CFP, a financial advisor from Ohio has stated that volatility is the cost of investing in assets that offer the best chances of reaching your long-term financial goals.

Think of Market Volatility As An Opportunity

One method for coping with market volatility is thinking about how you can buy more stock while the market is in a bearish state.

This is especially true when speaking about stocks that have done well in recent years since it offers us the opportunity to obtain these stocks at lower prices.

Again, try to look at volatility as something that will be better for your portfolio in the long run. Do not get so intimidated by it that you miss out on all of the possibilities.

Maintain A Healthy Emergency Fund

Volatility in the market is not necessarily an issue unless you need to liquidate an investment. This is why I would recommend you have a minimum of 3-6 months of living expenses saved.

Having an emergency fund will prevent you from having to sell off assets if there is a drop in the market.

If you are considerably close to retirement age, it is recommended you set aside at least two years of expense funds. This can be any mixture of life insurance, bonds, cash, home equity conversion mortgages, and home equity lines of credit.

When the market starts to decline, take money from one of those accounts and wait until the market is doing better before making any withdrawals.

Balance Your Portfolio As Needed

Be mindful of the fact that your assets may not be allocated as you initially desired after there have been extreme changes in either direction.

When this happens, it may be necessary for you to rebalance your portfolio so that it can be more in line with the investment goals and level of risk you desire. When trying to find the correct balance, sell any assets that are taking up a larger portion of your portfolio than you are comfortable with. Use the funds from this transaction to purchase more of any asset types that have gotten smaller with time. If you notice that your allocation is more than five percent more than you initially planned, it is time to take a step back and make changes.

The Nitty Gritty on Market Volatility

You are not abnormal if you are worried about there being times when the market is volatile. It can be frightening to look down and see that you are experiencing losses. Just remind yourself that this is normal and the companies you have invested in will do what they can to address this crisis.

Companies tend to be far more resilient than some give them credit for and some of them have done amazing when handling unexpected situations. It may seem like fear is the most natural response, but I urge you to remain as calm as possible. Historically, those who have been patient have done well for themselves. This is even true for times like the Great Recession, when the US stock market experienced heavy volatility. Over the long term, those who held on were treated to around 10% annual returns on average.