Demystifying volatility

Market fluctuations are normal and largely unavoidable, but are they also something to fear?

Ellen Sheng, guest author
4 minutes
People are turned upside down in the loop of a giant rollercoaster, set against a blue sky.
Volatility is an inevitable part of investing. Wild market swings may make some investors uncomfortable, but understanding and accepting market fluctuations is key to a long-term wealth management plan. © istock/ManunNgueampha

Given the turbulence of the stock markets over the last few years, starting with the pandemic, there's been increasing interest in how volatility affects investment portfolios. While volatility can be nerve-wracking, it is an unavoidable feature of markets and not necessarily something to avoid. So what exactly is volatility?

Measuring volatility

In finance, volatility refers to how much trading prices vary over time. It's commonly assessed using standard deviation, which measures the amount of variation in a data set relative to the mean. When the standard deviation is low, there is little deviation from the mean. When it's high, there's more deviation and more volatility.

Volatility in and of itself doesn't tell you anything about the direction of the returns.

Derek Horstmeyer, Professor at George Mason University School of Business

Another important measurement of volatility is the CBOE Volatility Index, often called by its ticker symbol, VIX. This index measures the market's expectations for volatility over the next 30 days, and is sometimes known as the fear index. When there is more uncertainty and more volatility, the VIX is higher. When market sentiment is more optimistic, with less anxiety, values are lower.

A man in a white shirt and glasses smiles at the camera, with nature in the background.
Professor Derek Horstmeyer specialises in the performance of exchange-traded funds and mutual funds.

Unlike standard deviation, which looks at past data, the VIX looks forward and measures volatility by tracking S&P 500 index options trading. Options are contracts that give investors the right, but not the obligation, to buy or sell stock at a specific price by a certain date. By tracking the prices of options, the index provides a glimpse into market sentiment regarding the near future. The option prices are weighted, giving prominent, market-moving options more heft, to get a more accurate picture of overall sentiment.

Notably, volatility doesn't measure whether markets are heading up or down, but how much they've been fluctuating, or might fluctuate, in the near future.

"It can be an up market or a down market when you have bouts of volatility. Volatility in and of itself doesn't tell you anything about the direction of the returns," says Derek Horstmeyer, a professor at George Mason University School of Business, who specialises in the performance of exchange-traded funds and mutual funds.

High-volatility funds yield higher returns

People, some in blue coats, look at computer screens or talk animatedly on the phone while raising their hands to a man.
High volatility funds returned an average of 5.81 per cent per annum compared to 2.51 per cent for low volatility funds - a trend that is even more pronounced in emerging markets. © UPI/Brian Kersey/laif

Volatility plays an important role in assessing potential returns and investment risk. In a recent study, Horstmeyer set out to determine if high- or low-volatility strategies yield higher equity returns. Drawing on data from Morningstar Direct on low- and high-volatility mutual funds and ETFs over the past decade, he found "clear and unequivocal" evidence that high-volatility funds yielded much higher returns than low-volatility funds.

US high-volatility funds earned an annualized return of 15.89 per cent on a post-tax basis over the past ten years, compared to 5.16 per cent over the same period for low-volatility funds. The results were similar when looking at global funds, excluding the US. High-volatility funds returned an average of 5.81 per cent annually versus 2.51 per cent for low-volatility funds. For emerging markets, high-volatility funds returned an average of 4.55 per cent annually versus 0.11 per cent for low-volatility funds.

Risk and volatility are often used interchangeably, but they are not the same thing.

Volatility is an important factor to consider when investing, but this doesn't mean it should be avoided. Volatility doesn't indicate if prices are heading up or down. But the more volatile prices are, the more opportunity there is to buy low and sell high. When there is high volatility, "there are more chances to have big differences in the price. You have more chance of buying bargains when prices are volatile. So if you're a long-term investor, volatility should be a positive. But many investors don't look at it that way," says Robert Johnson, a professor of finance at Creighton University's Heider College of Business.

Eine Scheune inmitten einer landwirtschaftlich geprägten Umgebung
Famed investor Warren Buffett bought farmland when the price dropped from USD 2,000 an acre to USD 600 an acre - an example of a change in sentiment with no change in risk. © istock/IamVagabond

Younger investors interested in capital growth have many years to invest and can afford to have more volatility in their portfolios. Conversely, older investors near to or in retirement, and generally interested in capital preservation, might want to stay away from volatility. That's because if markets decline by more than 30 per cent in a year, as they did during the financial crisis in 2008, there is less time for the investments to recover.

Volatility vs risk

When talking about investing, risk and volatility are often used interchangeably. But they are not the same. Volatility measures how much prices move around. Risk, on the other hand, is the possibility that something bad could happen.  

Johnson acknowledges that the two terms are used interchangeably in finance, but it's important to differentiate them. To explain the difference, Johnson likes to cite an example from famed value investor Warren Buffett, who bought farmland when the price dropped to USD 600 an acre from USD 2,000 an acre.

A woman looks at a screen, her hands folded under her chin, a little worried and thoughtful.
Investors can see whether the company has a sustainable business model as an indicator of risk - a fundamental element of volatility that is often overlooked. © istock/PeopleImages

"If volatility equals risk, people would say that buying farmland at USD 600 was more risky than at USD 2,000," Johnson explains. "But the farmland wasn't any more risky than before; it was simply market sentiment about farmland that lowered the price."

Another example that illustrates the difference: certain chip stocks have risen 300 per cent in the last year because of the sudden interest in artificial intelligence. A 300 per cent increase in one year makes a stock volatile, but that doesn't mean it's risky.

Of course, there are times when an investment is truly more risky because the stock price may very well drop further. And that kind of risk is something to look out for when investing. Johnson points to two types of risk: business risk and price risk. Business risk is the risk that internal or external factors could put a dent in a company's financial results. Price risk is the risk that a security or portfolio could decline due to factors like market dynamics, interest rates, or global events, and should not be confused with volatility.

A man in a suit and tie is smiling into the camera.
Robert Johnson, professor of finance at Creighton University's Heider College of Business. © istock/IamVagabond

Business risk is crucial when looking at a particular stock for long-term investment. Johnson believes that investors should focus on assessing if the company has a sustainable business model. "That's a better indicator of risk than if the price moved 50 per cent in the last year. This is the fundamental thing about volatility that is mistaken by investors," according to Johnson.

Volatility is an unavoidable part of investing. While seeing wild swings on the market can make some investors uneasy, understanding and accepting that market fluctuations are a normal part of investing is key to staying on track with a long-term wealth management plan.

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