When the stock market is making large up and down moves on a regular basis, you may hear that we're in a "volatile" market, but what does that mean?
While the word volatility is often used to describe general stock market action, or big movements in a certain stock, there's quite a bit more to the concept of volatility than that.
So, here's a look at what volatility really means, important volatility-related information investors should know, and what volatility can teach you about your risk tolerance.
What is volatility?
A more specific definition of the word volatility when it comes to the stock market is how large the price movements of a stock or index have been (or are expected to be). Without turning this into too much of a statistics lesson, the key point to know is that volatility is a measurement of the standard deviation of returns from a stock index or individual security.
Many investors associate volatility with stock market crashes and corrections — and for good reason. When the market is falling, large moves are certainly more common. In other words, stocks occasionally crash to the downside, but they seldom "crash" upward.
For most of the past five or so years, stock market swings of 1% or more in either direction weren't terribly common. But in March 2020, when the Coronavirus outbreak hit, moves of 5% or more became the norm for a while.
Having said that, while volatility usually picks up when the market crashes, it's important to realize that volatility can go in both directions. For example, if you hear that a stock is "more volatile than the overall market," it doesn't necessarily mean the stock is more likely to fall. It just means you should expect larger price swings.
So, think of volatility as the uncertainty involved with investing. If the S&P 500 is volatile, it means there's a wide range of potential returns. If a stock is volatile, it means the short-term price movements of the stock are likely to be more dramatic than a stock of average volatility.
While there are many different methods analysts use to calculate and assess volatility, there are two main types of volatility metrics: historic volatility and implied volatility.
Historic volatility calculations involve analyzing a stock's (or index's) previous price action, while implied volatility is a metric that shows how volatile investors expect a security or index to be going forward.
With that in mind, here are the two important volatility metrics for investors to know.
Beta can tell you how volatile a stock usually is.
If you look at a long-form stock quote through your brokerage or through a financial news outlet, there's probably a metric known as beta listed somewhere in the quote information. Beta is a measurement of a stock's historic volatility compared to the S&P 500 index.
A beta of more than 1 indicates that a stock has historically moved more than the S&P 500. For example, a stock with a beta of 1.2 could be expected to rise by 1.2% on average if the S&P rises by 1%. On the other hand, a beta of less than 1 implies a stock that is less reactive to overall market moves. And finally, a negative beta (which is quite rare) tells investors that a stock tends to move in the opposite direction of the S&P 500.
The VIX gives you a current snapshot of the market's volatility.
The CBOE Volatility Index, also known as the "volatility index," or simply "the VIX," is a measurement of the expected volatility in the market over the next 30 days.
The number itself isn't terribly important to understand, and the actual calculation of the VIX is quite complex. What is important for investors to know is that the VIX is often referred to as the market's "fear gauge," meaning that if the VIX rises significantly, investors could be worried about massive stock price movements in the days and weeks ahead.
Why is knowing volatility important?
To be clear, this isn't an exhaustive discussion of all of the volatility terms that exist in the investing world, but they are perhaps the most important volatility-related concepts for everyday (nonprofessional) investors to know and understand.
By understanding how volatility works, you can put yourself in a better position to understand the current stock market conditions as a whole, analyze the risk involved with any particular security, and construct a stock portfolio that is a good fit for your growth objectives and risk tolerance.
Your relationship with volatility.
The past several months have offered an opportunity for investors to reevaluate their risk tolerance. One way to assess your willingness to withstand risk is to reflect on your emotional reactions to the recent swings. If they kept you from sleeping and caused churning in your stomach, it might mean your portfolio is too aggressive. If, on the other hand, you felt OK and went so far as to add cash to your portfolio, you might be positioned perfectly or could even be more aggressive. Ideally, your financial strategy should create a sense of calm, not angst. Thus, your emotional reactions to market volatility are, in our opinion, definitely worth paying attention to.
At Motley Fool Wealth Management, we talk with clients about their risk tolerance and work with them to find an investment strategy that works best for them.