When a stock's share price swings dramatically in a short time, it's experiencing volatility. When this volatility affects many stocks, investors may start to worry about broader trends, such as what the volatility could be hinting about the health of the economy. While sometimes unnerving, navigating ups and downs is a normal part of investing. Understanding more about volatility can help you handle it when it inevitably happens.
What is volatility?
Volatility is a significant, unexpected, rapid fluctuation in trading prices due to a large swath of people buying or selling investments around the same time. In the stock market, volatility can affect groups of stocks, like those measured by the S&P 500® and Nasdaq Composite indexes. Individual assets, like stocks and commodities, can experience volatility too, with big changes in either direction to their share price. Smaller price changes also happen just about all day, every day to many assets.
How does volatility work?
Volatility can indicate how risky or unpredictable a security—like a stock, mutual fund, or exchange-traded fund (ETF)—is based on how much its price changes from its recent average price. Generally, higher volatility (when prices are jumping around a lot) indicates a riskier security. Lower volatility (when the price stays relatively steady) suggests a more stable security.
Types of volatility
There are 2 main types of volatility: implied volatility and historical volatility.
Implied volatility
Implied volatility (IV) estimates how volatile an underlying stock is based on option prices. Options are legal contracts that give investors the right to buy or sell a security for a certain price by a certain future date. The prices in these contracts show what the options market anticipates a stock's future value may be. Investors can then take these contract values and run them through an option-pricing model, like the Black-Scholes, to calculate what their implied volatility may be over time. IV values are presented as percentages that indicate how much a stock's price may rise or fall during a set period. (The Black-Scholes model is a mathematical equation that estimates the value of option contracts in theory, based on multiple factors including current price, time to expiration, and expectations for dividends and interest rates.)
Historical volatility
Historical volatility (HV) uses real-world, historical data to tell you the amount a stock's price has been above or below its average value for a specific period. It's also provided as a percentage and can tell you how volatile the stock has been previously. While past performance can’t predict future results, generally, a security that has high HV might also be expected to be volatile going forward.
What causes volatility?
A number of triggers can cause market volatility. But in general, investors react to uncertainty and may make changes to their portfolios based on how those certain triggers make them feel. That's why factors contributing to volatility include the following:
Government policy
New or different policies can lead to uncertainty. That’s because people might not know how long debates or new rules will last, how strictly they'll be enforced, who they'll affect most, and what their outcomes will be. Unsettled plans, like a federal budget lawmakers are still working on, could likewise unsettle markets.
Economic conditions
Investors worried about an impending recession or rising inflation, which could raise interest rates, could send share prices up or down. Again, investors not knowing how things will shake out could cause market shakiness.
Companies' financial data
If formerly highly valued public companies are losing steam (or lower-value ones are quickly rising), their stocks may be more volatile as investors digest the changes. Surprises on earning reports—essentially a quarterly report card, detailing a company's financial performance—could do the same. If a company beats or misses revenue expectations, their stock price could bounce around.
Geopolitical tensions and world events
What happens around the world could impact stock prices in the US. In addition to events like war or political unrest, it could be something environmental-related like a drought in a cocoa-producing country making chocolate scarcer, sending the price for that commodity up, and possibly affecting the stock prices of public companies that make or sell cocoa products.
How long does volatility normally last?
There is wide variation for how long volatility tends to last, but one thing's for sure: Volatility is common. Since 1980, the S&P 500 has experienced a drop of 5% or more in 93% of calendar years.1 Despite those frequent declines, the market's average calendar-year return over the same period has been more than 13%.2
There have been many bouts of volatility that haven't led to steep declines, though at times it has. Research shows corrections (generally considered a decline of 10% from recent highs) have lasted an average of 115 days3 and bear markets (at least a 20% decline) have lasted a median of 19 months.4
How to calculate volatility
The technical calculation for volatility is standard deviation (how much a stock price differs from its average price over time) multiplied by the square root of the number of periods of time being evaluated. A simpler way to calculate volatility is to look at "beta," or its historical volatility relative to the S&P 500's performance.
How is volatility measured?
Volatility is measured in a few main ways, depending on whether you're examining the volatility of individual stocks or the overall stock market.
The VIX
One way to measure volatility is the Chicago Board Options Exchange (Cboe) Volatility Index, or the VIX, often called the "fear gauge." It’s a benchmark of the expected volatility of the S&P 500 over the next 30 days, based in part on option contracts. When there's a large disparity between the prices investors are targeting for the same securities in the future, the VIX is higher. According to long-term data from the Federal Reserve of St. Louis, the average VIX value is 20, though it can spike in periods of uncertainty.
Beta
Individual stocks have a "beta" that measures a stock's volatility relative to an index like the S&P 500. A beta of 1 means a stock will generally follow whatever the index is doing. As in, if the benchmark index goes up or down by a certain amount, so too will the stock generally. Betas of more than 1 indicate the security is more volatile than the index, and less than 1 indicates the security is less volatile than the benchmark.
Maximum drawdown (MDD)
Maximum drawdown measures the difference in price from an investment's peak to its lowest point over time, which can indicate future volatility. Lower MDD signals lower volatility and steadier returns than higher MDD values, which could mean greater price fluctuations.
How can volatility affect investors?
Volatility may cause some individuals to panic-sell investments to avoid additional losses. However, it introduces a new problem: possibly missing out on a rebound in prices and needing to pick the right time to reinvest to maximize profits in the future, which is very difficult to do. Plus, markets have historically recovered—if not reached new heights—after turbulence, though past performance is no guarantee of future results.
How to navigate volatility
You can't control what happens to market prices, but you can control what you do when that happens. Here are a few ideas to consider during volatile markets:
Commit to your investing plan
If you're a long-term investor, having an investment strategy in place that accounts for your financial situation, goals, time horizon, and risk tolerance could encourage you to stay invested in all market conditions. History has shown that disciplined investors have come out ahead by not selling when volatility increases. On average, the total return for the S&P 500 index in the 12 months after the market bottomed out during a recession is 38%.5
Rebalance if needed
Volatility might be an opportune time to rebalance your portfolio, or adjust your investment mix to better align with your target allocation and help maintain diversification. Diversification is spreading your money across different kinds of investment types and specific investments so if one kind is dropping, another might be rising. A diversified mix could help you weather market ups and downs.
Invest consistently
When the market's down, it may be an opportunity to get more for your money. Dollar-cost averaging, or investing the same amount at a regular cadence, allows an investor to purchase more shares when prices are low. The reverse is also true: You'd buy fewer shares when prices are high. This recurring investment strategy can remove some stressful guesswork—you've already decided when and how much to invest.
Dollar-cost averaging does not assure a profit or protect against loss in declining markets. It also involves continuous investment in securities, so you should consider your financial ability to continue your purchases through periods of low price levels.
