- What is stock market volatility?
- How is market volatility measured?
- What causes market volatility?
- What is causing the recent stock market volatility?
- Why does stock market volatility change over time?
- How to deal with market volatility
- 1. Tilt your portfolio to less market-sensitive investments
- 2. Ensure you have a sufficient allocation to bonds
- 3. Stay the course for the long term
Price movements of any kind can be unsettling, but a market decline is just never a good feeling. We hear you, and we’re in it with you.
However, a volatile market is par for the course when it comes to investing. And remember, the market has to go down sometimes in order to come back up.
So, what is market volatility and how should you deal with it? Let’s break it down.
What is stock market volatility?
Stock market volatility is a measure of how much the investable stock market fluctuates up or down. When investors talk about stock market volatility, it’s usually in reference to a specific stock index (e.g., the S&P 500 or the NASDAQ) or a particular geography (e.g., the U.S. or Canadian market). When the market is volatile, it is showing higher-than-usual movement.
Stock market volatility creates uncertainty for stocks held by investors, called market risk. This is the unavoidable fluctuations in your investments caused by the broader market’s moves.
All stocks have market risk, regardless of how sound their fundamentals may be. For example, a bad stock market crash is likely to affect even blue-chip stocks with solid balance sheets and cash flows.
How is market volatility measured?
Stock market volatility is primarily measured by the Chicago Board Options Exchange’s (CBOE) Volatility Index, otherwise known as the VIX. At any given time, the current VIX index value reflects the expected annualized change in the S&P 500 index over the following 30 days, based on options data.
Colloquially, the VIX is known as “Wall Street’s Fear Index.” A sudden spike in the VIX is a sign of high current market volatility and is almost always accompanied by a drop in the S&P 500 Index. This makes the VIX a good indicator of current and expected market volatility.
Market volatility can also be measured by the standard deviation of various indexes. This metric reflects the average amount the value of an index has moved around the mean over a period of time, such as one, three, five, and ten years. A volatile index such as the NASDAQ 100 is likely to have a higher standard deviation, as its value will fluctuate more compared to historical volatility averages.
Finally, market volatility can be measured by comparing the beta of various individual stocks. Beta measures a specific stock’s sensitivity and direction relative to the overall market (usually a market in the same geography as the stock, such as the S&P/TSX Composite for Canadian stocks). The market always has a beta of 1.00, and stocks can have a beta of:
- Greater than 1.00 (moves in the same direction as the market and with more sensitivity)
- Less than 1.00, but greater than 0 (moves in the same direction as the market, but with less sensitivity)
- Less than 0 (moves in the opposite direction to the market)
What causes market volatility?
The causes of market volatility are complex, but the following behavioural and economical factors generally lead up to greater-than-usual market volatility:
- Central bank monetary policy announcements (interest rate hikes, quantitative easing/tightening)
- Economic indicator releases that come in under/over expectations (Consumer Price Index/inflation, employment figures, gross domestic product)
- Systemic risk, in the form of large “too big to fall” financial institutions facing liquidity issues (like what happened in 2008 with Lehman Brothers, Bear Sterns, and AIG)
- Poor earnings reports from mega-cap stocks that dominate stock market index weightings (such as Apple, Microsoft, Amazon, Tesla)
- Contagion from volatility in the cryptocurrency market
- Global socio-economic instability and geopolitical conflicts
- Higher-than-usual trading volume, especially in the derivatives market (e.g., a “quadruple witching” event, usually a Friday on which stock index futures, stock index options, stock options, and single stock futures expire simultaneously)
What is causing the recent stock market volatility?
Market volatility throughout 2022 has been high, thanks to a number of events:
- Inflation running red-hot, with May’s Consumer Price Index report coming in at an 8.6% year-over-year increase
- The Bank of Canada and the U.S. Federal Reserve announcing several interest rate hikes to quell inflation
- Multiple high-profile poor earnings reports from mega-cap stocks such as Meta Platforms, Netflix, Walmart, and Target
- Supply chain constraints, especially for fuel, semiconductors, and certain foodstuffs like wheat
- The Russian invasion of Ukraine
Why does stock market volatility change over time?
Market volatility is a mean-reverting phenomenon. That is, over long periods of time, volatility will settle back down to the historical average. The reasoning behind this is that the events that cause market volatility are temporary in nature.
Once markets have adjusted to the effects of these events (have “priced them in”), market actors like investors and traders will go back to business as normal, until the next event sends volatility soaring again.
Over many market cycles, volatility will ebb and flow, so it’s important to accept this and not try to time the market. Many investors have attempted to short or go long volatility with disastrous results.
How to deal with market volatility
Market volatility can be upsetting for many new investors to deal with. Seeing your portfolio value fluctuate day over day can be a significant source of stress, even if your investment choices are sound. Here are some tips on how to cope with market volatility.
1. Tilt your portfolio to less market-sensitive investments
An asset allocation to low-beta large-cap stocks with a lower standard deviation might be a good idea for investors looking to minimize the effects of market volatility. Historically, stocks from the health care, consumer staples, and utilities sectors have low beta, meaning they’re less sensitive to price volatility. This translates to lower sensitivity to the market’s movements and less volatility. Investors can use various stock screeners to find these.
2. Ensure you have a sufficient allocation to bonds
As a fixed income instrument, bonds have a much lower correlation to the stock market. In general, they tend to be lower risk, lower return investments. This makes an asset allocation to investment-grade (BBB, A, AA, AAA) bonds a good option when it comes to reducing volatility.
Some bonds like U.S. Treasuries can even gain value during bad crashes as interest rates drop and a “flight to quality” occurs. Common allocations to bonds include 10%, 20%, and 40%, depending on an investor’s risk tolerance.
3. Stay the course for the long term
Often the best investment strategy is maintaining a long-term perspective and accepting the current market volatility. If your investment objectives are years or decades away, it can be helpful to remember that volatility is a mean-reverting phenomenon and poor market conditions won’t last forever.
Consistently contributing to a well-diversified portfolio of high-quality stocks can set investors up for success in the long run, no matter how volatile the market is at the moment.