Chances are you’ve heard about stock market volatility. Perhaps you were listening to the nightly business news or maybe reading the investment section of the newspaper. It’s a term that gets thrown around a lot, but what is it and why should you care as an investor?
What is volatility and how is it measured?
Volatility is the degree to which the price of an asset (such as a stock) fluctuates. A stock that’s plunging one day and soaring the next is said to have high volatility, whereas a stock whose returns are relatively consistent is said to have low volatility.
There are actually a few ways to measure market volatility. One method is to look at what’s called historic volatility. Historic volatility, as the term suggests, is backward looking and is a calculation of how volatile a stock has been in a specified period of time. For example, you could measure how volatile a stock was in the last 30 days, the last 12 months, or even the last five years. In this regard, it’s possible that a stock that typically has low volatility over the longer term may have experienced a bout of higher volatility more recently.
If historic volatility is what has happened, then implied volatility is a measure of what investors expect will happen in the future.
Implied volatility can be measured both on individual stocks as well as the broader stock market. With regards to the latter, the business press often quotes something known as the Volatility Index (also known as the VIX). A low VIX means the market is expecting low volatility and a high VIX shows investors are expecting heightened volatility.
As a simple rule, when volatility is low, the stock market tends to rise. Investors become less fearful and there aren’t wild up and down swings in the market. Rather, stocks go up in a steady but not erratic fashion.
The opposite is true when volatility spikes. In this case, the market tends to fall.
How to protect yourself
We are currently experiencing a period of exceptionally low volatility, which has led some financial experts to warn that market turbulence may be around the corner. A period of low volatility in and of itself doesn’t mean a crash is coming. But it can be a sign that investors aren’t worried enough about the possibility of a market decline.
With this in mind, it’s worth putting your money in either GICs or high-interest savings accounts, which are good ways to lower the overall volatility of your portfolio. You’ll be glad you did when the market takes its next dive.
- How GICs Can be Part of a Diversified Investment Portfolio
- The Importance of Diversifying Your Portfolio
- 5 Mistakes Every Investor Should Avoid
Flickr: Andreas Poike