What do we mean by volatility?
Some people dismiss the share market as ‘too volatile’. Others find thrill or opportunity in the volatility of shares. So, how should we view volatility in the context of successful, long-term investing?
In a financial setting, volatility simply refers to the fluctuation of asset prices over time. All assets are volatile to some degree, with the prices they command moving around regularly in response to economic and other factors.
We see this in all types of financial markets, like those for property, bonds, cryptocurrencies, and commodities (like gold).
But volatility is perhaps most often discussed in connection to share prices and the stock market.
Why? Well, the unique liquid nature of the share market – combined with its mainstream use — means that the general public is often concerned by dramatic changes in stock prices.
Most people have the majority of their retirement savings invested in shares, either through personal investments or superannuation. As a result, market fluctuations – particularly large falls – can significantly impact their wealth.
The maths
Mathematically, volatility is captured by a share’s standard deviation of returns, which is a measure of dispersion around its mean (or average) price.
Don’t worry, we won’t bore you with formulas. But, suffice to say: a company with a share price that changes a lot each day – particularly where the magnitude of those changes appears to be random — would most likely have a high standard deviation.
Its shares would be considered to be far more volatile than a company with a stable share price or one with a share price that increases (or decreases) at a steady rate over time.
The contributing factors
Many factors can contribute to market volatility, often simultaneously and at varying market levels.
Macroeconomic events can send shockwaves across financial markets. Macro events include wars, trade disputes, geopolitical tensions, global pandemics, and other major disasters.
In addition to macroeconomic events, there are industry-specific headwinds that affect specific sectors of the market in isolation. For example, COVID-19 lockdowns negatively impacted the travel and tourism sector while at the same time providing a massive tailwind for the e-commerce industry.
Company-specific news can also create volatility in its share price. Investors use company announcements and financial reports to decide whether or not to invest in these companies. This means that any unexpected news put out by the company can cause significant movements in its stock price.
For example, a surprisingly positive earnings result may cause a company’s share price to rise dramatically. On the other hand, reports of changes in company leadership may concern investors and cause them to sell their shares, driving the share price down.
As you can imagine, all manner of different company announcements can affect share prices in different ways.
What is a high or low volatility share?
When a share is described as being high volatility or low volatility, its price movement is typically compared with movements in the broader stock market, often represented by an index such as the S&P/ASX 200 Index (ASX: XJO) or S&P/ASX All Ordinaries Index (ASX: XAO).
Generally, stocks that fall into the growth shares category tend to display higher levels of volatility than value shares or ASX blue chips. This typically involves outperformance against an index during bull markets and underperformance during bear markets.
In contrast, companies that tend to have resilient and predictable cash flows, like utilities or infrastructure providers, tend to be low-volatility shares. These might underperform during bull markets but provide higher levels of capital protection during bear markets.
Volatility and risk
Volatility is such an essential metric in the world of finance because it is often considered to be a proxy for risk. The more volatile an asset’s price, the riskier we consider that asset to be.
Consider a junior company that has just been listed on the stock exchange. Because little is known about it, and there is no historical financial performance for investors to draw insights from, their share prices can react strongly to company updates and other news.
This makes their share price very volatile – hence why investing in them is considered so high risk. One piece of bad news, and your entire investment might go down the drain!
But one piece of good news, on the other hand, and its share price could skyrocket.
This is what’s known in investing as the risk-return tradeoff. Unfortunately, it usually goes that the greater the potential payoff, the more likely you are to lose everything chasing it.
Thinking about how you would react to volatility is a good way to evaluate your risk tolerance. If the idea of the value of your investments fluctuating wildly from day to day makes you break out in a cold sweat, then you’re probably pretty risk-averse.
But if you can keep a cool head when confronted with short-term losses while focussing on the potential long-term returns on offer, you can probably stomach investing in higher-risk shares.
Your risk tolerance will entirely depend on your personal circumstances, financial situation, and investing goals.
The volatility ratio
We can measure volatility in various ways, either for individual shares or across an entire market.
How volatile a share is compared with a broader benchmark index is often measured with a metric known as the stock’s beta (β). If a company’s share price rises and falls entirely in line with its benchmark, it will have a beta of one.
A beta of less than one indicates that a particular share has a history of being less volatile than its index benchmark. This might mean that for every 1% rise in the benchmark index, the given share’s price might only rise 0.8%. But it also implies that for every 1% fall in the index, the given share’s price would only fall 0.8%.
Likewise, a beta greater than one implies greater historical volatility than the index. High-growth shares, for example, usually have a beta much greater than one because they typically outperform in a rising market but underperform when prices fall.
When the entire share market is volatile
So far, we have talked a lot about individual shares, but what about the stock market as a whole?
The stock market itself can go through periods of heightened volatility. These usually coincide with times of economic, social or political upheaval, when even the near-term future becomes increasingly difficult to predict.
So far, 2022 has been a very volatile period for financial markets, including the ASX share market, with investors having to deal with rising interest rates, high inflation, the lingering effects of the COVID-19 pandemic, the war in Ukraine, and massive supply chain disruptions, to name but a few.
A history of volatility
We don’t have to go too far back in time to find examples of extreme volatility. In the past 25 years, financial markets have suffered through the dot-com bubble of 1999, the 2008 global financial crisis, and most recently, the 2020 market crash driven by the COVID-19 pandemic.
And wedged between these significant market events have been shorter periods of volatility, including corrections and flash crashes.
This tells us that periods of heightened volatility are pretty standard – and are possibly even becoming more frequent. So, although these periods may cause us stress and anxiety, we should understand them to be a natural part of the market cycle.
VIX – The volatility index
While a volatility ratio measures the volatility of an individual share against a benchmark, investors typically use a volatility index to gauge the volatility of the benchmark itself against its historical levels. Volatility, by nature, is unpredictable.
Take the ASX 200’s performance in 2020 and 2021 as an example.
In 2020, ASX 200 shares crashed by 32.5% between mid-February and mid-March due to the onset of COVID-19, only to rebound 36.7% by the end of the year. As such, we can consider 2020 a high-volatility year for ASX 200 shares.
In contrast, 2021 provided a reasonably smooth run for the ASX 200. The index appreciated 13.02% over the calendar year, with no significant market corrections or crashes. As such, we can describe 2021 as a year of relatively low volatility.
Investors use an ‘index of an index’ to measure this market-wide volatility. In Australia, the S&P/ASX 200 VIX Index (ASX: XVI) is considered the gold standard in measuring market volatility.
A high VIX indicates the market is expecting significant shifts in the value of ASX shares, up or down. In contrast, a low VIX indicates investors are expecting things to more or less carry on as they are.
To see how this works, take a look at the ASX 200 VIX over the past five years below:
ASX 200 VIX and ASX 200 index over five years. Source: Google Finance.
Does volatility matter?
Theoretically, an individual share’s volatility doesn’t make it a good or bad investment in and of itself. A company’s ability to bring in and grow revenue and earnings dictates its potential success or failure as an investment asset.
Many investors actually enjoy the volatility the share market can bring. Wild price swings can be mentally painful but offer opportunities to buy shares at cheaper valuations (sometimes referred to as buying the dip).
The biggest thing to remember regarding volatility is its emotional impact on investors. Many investors simply can’t stomach holding a volatile investment over a long period.
They might celebrate and buy more shares in a company if its price moves sharply upwards, hoping to double up on a winner. But if the share price falls, investors may panic and sell out, cementing a painful loss.
Both of these hypothetical decisions are emotional in nature. You are more likely to make such decisions if you are a nervous investor and hold shares with a history of volatility compared to the broader market.
Stay calm and carry on
On the surface, market fluctuations can seem unpredictable, frightening, and often downright confusing. But it’s important to tune out the noise and focus on what matters most: growing your wealth over time.
This means we shouldn’t be overly concerned about short-term price movements. It’s important to remember that the share market has consistently generated strong average annual returns over time.
An effective way to minimise the volatility of your investment portfolio is to buy shares in many different companies. Building a diversified portfolio of companies operating across multiple different industries can help reduce your overall risk. Because the share prices of these companies will often respond to news and events in different ways, losses in one section of your portfolio can be offset by gains elsewhere.
Ultimately, we all have to handle market volatility to varying degrees if we want to invest in ASX shares. It can be your friend or enemy, so choose wisely and lean towards ASX shares with a volatility profile that suits your particular investing temperament and risk appetite.