Apr 19, 2022
What is volatility in the market?
When investing in the stock market, volatility is one of the terms you’ll hear frequently. Volatility is a measure of risk related to financial securities, including stocks, although it also applies to many other types of investments. In the simplest terms, volatility refers to how much the price of an investment tends to change over time.
Volatility is a measure of risk
When it comes to investing, risk isn’t necessarily a bad word. All investing involves some measure of risk that you could lose money. That’s where understanding volatility comes in: it can help you measure the amount of risk a particular investment carries.
Highly volatile investments are those that experience large price swings. A stock with lower volatility generally involves less risk than a stock with higher volatility, because the amount by which the value may drop tends to be lower. And while a higher volatility stock suggests greater risk, it may also provide the opportunity for a greater return if the price increases quite a bit.
You can think of stock market volatility like the waves on an ocean. When you’re rowing your boat on the open sea, some journeys are smooth sailing: small waves, pleasant breezes, clear skies, and straight-ahead navigation. Journeys to more exotic, hidden destinations, however, might require navigating waters that are a bit choppier, with bigger waves, unexpected gusts, and storms rolling in. If you have a more ambitious destination in mind, you might decide the more turbulent waters are worth the risk.
Stock market volatility and investing
Risk and change can be scary, particularly when your money is concerned. Knowing your risk profile can help you decide how much risk you’re comfortable with and, in turn, the level of volatility you can tolerate in your portfolio.
A higher volatility stock suggests more risk, but may also provide opportunity for a greater return.
If someone tells you they can predict the future of the market, run the other way! No one has that ability. Regardless of the futility of attempting to predict what the market will do, we all want reassurance that we’re investing with as much information as possible. That’s what volatility is all about: a measurement you can use to get more insight into the potential risks of investing.
We’ve learned to predict other uncertain things in our lives, like the weather forecast, based on available information. To navigate the waves of an unpredictable stock market, investors seek to forecast and analyze the volatility of stock prices. Two common ways to do that are looking at standard deviation and the beta coefficient.
What does standard deviation mean in stocks?
One way experts try to predict the risk of an investment is by looking at its behavior in the past. That might mean investigating the history of a stock or fund’s performance to gauge its realized, or historical, volatility. Based on that information, investors can calculate the standard deviation, a measure of how much the investment’s returns tend to vary from its average return.
A smaller standard deviation means a less volatile investment. The larger the standard deviation, the higher the volatility and, therefore, the higher the risk.
What does “beta” mean in stocks?
You might hear finance folks talk about “beta” in stock market volatility. They’re referring to something called the beta coefficient, which can tell you how volatile a stock is compared to the overall market.
Calculating the beta of a stock indicates whether it’s more or less volatile than the market as a whole or if it’s about the same. The market’s beta is 1.0. If a stock has a beta of 1.0, its volatility is the same as the market. If a stock has a beta of less than 1.0, however, it is less volatile. For example, a stock with a beta of 0.9 will move at a rate of 90% of the market. The same is true of the opposite: a stock with a beta over 1.0 is more volatile than the market. That might offer the possibility of higher returns, but it also carries more risk that the stock price will drop significantly.
What is volatility’s relationship to your portfolio?
Your investing goals and risk profile can help determine how much volatility you’re comfortable with in your portfolio. For instance, if you have an aggressive risk profile or are planning to keep your investments over a longer time period, you might be able to tolerate more volatility because you have time to weather the ups and downs of the market. Are you more of a conservative investor? Choosing securities with less volatility may better align with your risk tolerance.
Stash recommends a diversified portfolio in order to spread your risk across a number of different types of investments and help balance some of the possible risks of stock market volatility.
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