How much stocks go up and down is the key to sound investment decisions. By grasping the relationship between volatility and risk, investors will be in a better position to choose the portfolios appropriate to meet their long-term goals.
One can measure volatility in different ways, for example, it can be measured from historical and implied volatility. Volatility is part of investing – if you are a newbie or a veteran.
Causes
The drivers behind stock market volatility can be difficult to determine. However, understanding them can help to formulate ways to reduce the impact of risks at times when your fingers look like they’ve been through a shredding machine. No investments are risk-free, but volatile markets make it more difficult to maintain the value of your portfolio.
Volatility stems in part from uncertainty over what the market will do next. Investors repeatedly attempt to predict what the market will do a moment hence, and this can be in the absence of full information for assessing what happens next – knowledge (or belief) that could lead to a ‘bear market’ or to a ‘bull market’.
Other factors that contribute to volatility include economic events that move the market, changes in monetary policy or political chaos. Volatility can be caused by specific news for companies – an earnings report, a merger and acquisition, a change in management or a product announcement could affect the volatility of a specific stock. Your emergency fund could be your knight in shining armour as you delve into the world of greater volatility.
Measures
The ups and downs of the stock market can make investors queasy. They can cause short-term emotional decisions that erode returns over the long term, such as buying too many stocks on the upswing, or selling everything and running for the hills for fear of an imminent downturn. Insight into how volatility affects your portfolio and the market can help you develop new strategies to minimize risk and maximize returns.
These historical and implied volatility, with the latter referring to how much stock prices deviated from their mean over a time. Implied volatility, which reflects current economic conditions, is the opposite to historical volatility, which refers to past economic conditions. It is the measure used in the OECD’s volatility index. Financial contagion models increasingly look at how stocks have moved together in the recent past, and forecast future joint moves based on the prices of options contracts that cover them.
Things such as a company’s profits, investors’ sentiments or world events can cause volatility on the stock market, as can inflationary pressures and changes in interest rates, which may impact company financial performance or share price.
Trading strategies
Although large swings in markets are relatively rare, they can be very severe and detrimental to the health of your investment portfolio. They often cause a lot of panic among investors who in turn sell their investments without thinking it through, whether out of fear, panic or some other psychological burden. Volatility in your investment portfolio can be reduced through a few simple steps.
As examples, the investor may invest in less-volatile stocks; construct a portfolio with a low-volatility mix; adopt a low-risk strategy of trading with limited commitment per trade and more sensible stop-loss orders; dollar-cost average purchases of shares to avoid timing issues and automatically reinvest dividend payments, and dollar-cost average if the shares are purchased on an irregular basis (such as when the portfolio is funded with inherited cash).
Stick to a sound long-term investment plan. It is difficult not to pay attention to day-to-day news reports when markets are erratic, but you need to keep perspective if you are serious about being a long-term investor and if you see market dips and spikes as just part of the journey towards attractive returns.
Risk management
Market volatility is not the same as risk but, after long periods of quiet, high volatility can make losses more likely. Taking risk and losses into account, what does it mean to have a diversified portfolio and how might a diversified portfolio reduce overall risk? Business challenges – what do they have to do with required reading? From student life and developing skills to psychology and the workplace, consider these real-world questions that provide valuable context for required reading. There is often a desire to find a one-to-one relationship between risk tolerance and the makeup of an investment portfolio. Market volatility can influence or even determine an investor’s risk tolerance but, when it comes to risk, what we mean by risk is far more complex than this distinction suggests. Critical thinking requires students to understand the factors that influence risk – such as market volatility, investment outlook, investor sentiment, economic news, global events, and much more – and how each of these factors can reduce or increase overall risk.
During times of market volatility, inexperienced investors might be tempted to make knee-jerk moves that undermine market returns. Investors should try to keep their faith, however, and stay the course with long-term investment strategies such as dollar cost averaging and diversification.
Volatile markets can be scary for anyone, but especially for retirees who are depending on income from their investments. Financial professionals can help clients review their financial situation and investment goals, and help them to be ready to handle market volatility; they can remain calm while maintaining confidence that their well-diversified portfolio is exactly what they needed for just this type of scenario.
