As I’m sure young investors are aware, the term “volatility” is a common topic of discussion in the financial media, but there’s more to the story than just the normal ups and downs of the stock market. So, what is market volatility, how is it measured and what are its potential effects on investors? Let’s take a look.
Investopedia defines volatility as, “A statistical measure of the dispersion of returns for a given security or market index.” In other words, volatility is the ups and downs of an individual security or of the market in general. But more than that, volatility is a sentiment indicator that provides clues about directions in the market. As such, measuring volatility can be a valuable tool for managing your portfolio.
NOTE: Volatility in the market is typically measured using the Chicago Board Options Exchange Index, a.k.a. VIX Index or VIX (further to its use as a sentiment indicator, the VIX is also known as the “Fear Index”). The VIX is forward looking and measures investor expectations about volatility over the course of the next 30-day period, and is calculated using S&P 500 Index option prices.
Because the VIX Index is somewhat short-sighted, we also look at the history of volatility in the markets going back to the 1920s. This allows us to segment the volatility record into different timeframes (decades, years, quarters, months, etc.) and evaluate where on the historical scale we might be at any given time. Mark Twain once remarked that history doesn’t repeat, but it sure does rhyme. Being able to identify “rhyming” patterns in stock market volatility is important information to have when managing investment portfolios.
Portfolio management is where the volatility rubber meets the investment road. For example, it’s true the volatility of a single security or sector can present buying opportunities; however, identifying and researching enough securities or sectors to provide adequate diversification is likely too complicated and time consuming for the average investor (we don’t do it and we do this for a living). And, trying to time the market and get in at lows or sell at highs is hard at best and potentially catastrophic at worst.
Of course no one likes volatility, especially at the extremes. In fact, many analysts view volatility as a product of bear markets and thus always take it as a negative. While there is some truth to this, most of our volatility indicators reach extremes toward the end of bear markets, so investors sometimes should embrace rather than shun volatility. Also, bulls and bears often coincide, which is why we take a slightly different perspective on volatility.
Now, if left unchecked, volatility, like inflation, can have a long-term deleterious effect on your portfolio, so designing your portfolio to dampen its effects is crucial. Typically, this is accomplished by adding non-correlated assets to help “smooth out” volatility and maintain a more consistent upward trend in your portfolio.
So, how do we cope with volatility the market? By understanding, not fearing, it. First, it’s important to remember that down days in the market are normal. Even several down days in a row aren’t all that unusual. Certainly, this kind of temporary choppiness is not indicative of market performance over an extended period of time. While it’s easy to get emotionally caught up in short-term fluctuations, they shouldn’t have much effect on a long-term investment plan.
At BlueSky Wealth Advisors, we believe time in the market, not market timing is the key to being a successful investor. History tells us that markets tend to go up over time and that’s why our investment management approach—which is based primarily on a long-term, strategic asset allocation—is its own best buffer against market volatility.
= = =
David L. Blain, CFA, is chief executive officer of BlueSky Wealth Advisors, LLC, an independent registered investment advisor (RIA) doing business as D. L. Blain & Co. in New Bern, North Carolina and Pleasanton Financial Advisors in Pleasanton, California. You can contact David at davidblain@blueskywa.com.
Related Reading
Read another story by Blain: Turn Your Trading Activities Into A Business
