What market volatility is and why it’s an opportunity

Key takeaways

* Volatility is intrinsic to the stock market.

• Though often looked upon as an element of risk, volatility can be harnessed to potentially deliver significant returns when properly played.

• A carefully balanced portfolio incorporating alternative investments can serve as a hedge against traditional public market volatility.

Generally, the pricing of major stock indexes such as the S&P 500 tend to fluctuate up or down a little each day. However, there are periods when the market sees much wider variations due to increased buying and selling activity, which analysts and professionals term “volatility”. 

Despite the concerns that often accompany it, volatility is part of the natural order of the stock market. With that in mind, it can be useful to look at what market volatility is and why it can be an opportunity for savvy investors.

Understanding market volatility and its potential drivers

In the simplest terms, market volatility is a measure of the frequency and magnitude of movement in the price of the market, an index, or individual stock. The degree of volatility evident is a direct reflection of how large and how often these price swings occur. So, there’s always some degree of volatility, it’s often just lower volatility. However, investors mostly talk about volatility when it means large price fluctuations over a short period of time. 

In most instances, market volatility can be traced to fear, which in turn is usually driven by the emergence of uncertainty. A recent example occurred in the wake of Russia’s initiation of military aggression in Ukraine. Investors didn’t know what its effect on the global economy would be, which resulted in a heightened period of selling as investors sought asset protection. The early days of the COVID-19 pandemic also triggered a period of extreme market volatility given the vast uncertainty connected to it. Presidential elections can ignite volatility as well. 

How to calculate the volatility of a stock – measuring standard deviation

Creating a data set that tracks a stock’s price changes over a given period is the first step toward calculating its volatility. Having a record of a stock’s closing price over a specific interval provides a baseline against which to measure fluctuations. These data points can be used to determine the percentage by which a stock’s price moves over a fixed period, as well as from day to day. The result of this measurement is known as the stock’s standard deviation.

While spreadsheet software such as Microsoft Excel can calculate this information automatically, it can be helpful to understand the algorithm by which the determination is made.

The first step is to calculate the average return (the mean) for the period under consideration. When considering a six-month period, one would find the total of six months of returns and divide the result by six.

Having calculated the mean, the next step is to find the square of the difference between the actual and the average rates of return for each of the six months in question. Totaling those results provides the numerator by which the number of data points (six in this case) should be divided—minus one.

The result of this calculation is the standard deviation. 

Standard deviation as an analytical tool

Comparing the standard deviation of a stock to its average annual return provides an indication of the volatility of that stock’s price over the given period, as well as its rate of return. Within the inverted bell-shaped curve of a normal distribution, an asset’s return typically falls within a single standard deviation of the average approximately 68% of the time. Two standard deviations occur 95% of the time and three standard deviations occur 99% of the time. 

On average, the market has returned an average of 10% annually. However, that should not be taken to mean the market will return 10% each year. 

However, it’s important to recognize that past results do not always serve as a prediction of future outcomes. In other words, while investment decisions should be based on more than an asset’s standard deviation, the calculation can be somewhat informative, in that the higher the standard deviation of an asset, the wider its price swings will likely be.

Investors with a long time horizon might not be put off by this volatility. However, holding on to volatile assets in active trading situations, or in circumstances in which the need for liquidity is high, it can entail a high degree of risk. 

Dealing with market volatility without jeopardizing returns

Investors should avoid panic selling, as well as any strong emotional behavior after a significant market drop. Analysts at the Schwab Center for Financial Research found that the largest gains in stocks have occurred during the first 12 months of a recovery from a bear market drop of 20% or greater. 

As an example, the 2020 bear market presented an opportunity to buy into an S&P Index fund for roughly 33% less than the price at which it was trading at the beginning of the downturn. Having previously posted a decade of continuous growth, the fund gained 65% from its low price and finished the year up 14%. In other words, selling during a bear market is almost always a way to miss out on your investment potential . 

Moreover, funds for which an immediate need exists should not be invested in the stock market. This underscores the importance of establishing an emergency fund in non-market correlated assets that is equal to three to six months of living expenses. This can help investors meet liquidity requirements during downturns and in the event of an emergency. 

Further, as the time horizon for your investment draws nearer, experts recommend broadening that safety net to two years of coverage. This provides an investor with a source of liquidity with which to wait out a bear market, while keeping their portfolio intact to maximize the benefit from the eventual turnaround.

Market volatility can be an opportunity

It is important to note that volatility and risk can go hand in hand for traders whose goals are to buy low and sell high. Volatility can also be an issue for retirement investors who may need to draw cash from their portfolios during a downturn without fear of having to return to the job market. 

Again though, given the inevitability of volatility, and the fact that it is intrinsic to significant growth, a portfolio should be designed with volatility in mind. What’s more, recognizing the potential for volatility that arises from certain events provides the savvy investor with opportunities to purchase high-performing stocks at a discount. 

Ultimately, long-term market returns, even during periods of extreme volatility, remain based on dividend yields, earnings growth, and changes in valuation. Thus, extreme market volatility can be looked upon as a sale opportunity to buy into opportunities that may have been out of reach before.

Embracing volatility and keeping long-term positions may help investors to benefit from future gains those assets may achieve. When stocks fall from recent highs, investors who buy when the market is down can benefit from rebounds. In other words, rather than succumbing to fear, worry and anxiety during bear markets, it is far more productive to see such periods as buying opportunities for stocks that routinely deliver strong performance.

Experiment with new investment types

Alternative investments can serve as a hedge against stock market volatility, though it should be noted that certain alternative investments also experience a high degree of volatility. Cryptocurrencies, for example, are notorious for volatility. Bitcoin started 2021 at just under $30,000 before soaring to $60,000 in April of that year. It then declined to $30,000 three months later, then went on to close the year at $46,000. While that represented an overall gain for the year, heavy investors in the cryptocurrency likely experienced more than a few sleepless nights, and those who invested at the wrong times may have experienced losses.

Other alternatives such as real estate investment trusts saw a gain of just over 40% during the same period, with much less volatility. Further, accessibility to alternative investments has expanded to several potentially lucrative asset classes, which in the past were restricted to wealthy accredited investors and institutional investors. Alternative asset classes are also typically less correlated with public markets, and thus experience less volatility during times that the market may be volatile. 

Willow Wealth was founded with the goal of improving access to private market alternative assets by making them available to a wider range of investors. While traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation, a more balanced 60/20/20 or 50/30/20 split incorporating alternative investments can make a portfolio less sensitive to public market volatility.

For more information about Willow Wealth’s investment opportunities, please visit our offerings page.