There is a lot of talk in the financial news about stock market volatility and “fear gauges” being elevated near all-time highs.
But what does this actually mean? How does it affect your portfolio? And what should you be doing in such situations to protect your investments?
Here’s what you need to know.
What is stock market volatility?
Share prices fluctuate up and down every day. And this, in turn, moves the stock market up and down, creating what we call market volatility. It’s simply a measure of the intensity of these fluctuations.
Typically, the word “volatility” only comes into the limelight when prices are falling. But as we just explained, volatility happens in both directions. This means it is entirely possible to have high price volatility when prices are climbing as well as falling.
There are two types:
- Historical Volatility – Measures how volatile an asset has been in the past
- Implied Volatility – Measures how volatile an asset is expected to be in the future
How is market volatility measured?
For the mathematicians in the room, you can calculate the volatility of any stock by working out the variance or standard deviation from historical price movements.
But the standard deviation isn’t really useful on its own since it needs to be compared to something. That’s where beta comes in. Beta compares the standard deviation of a stock with an index.
For UK shares, the index is usually the FTSE 100. And for US stocks, the S&P 500 is often the go-to option.
Simply put, the higher the beta, the greater the volatility of the stock compared to the market.
Here’s how to interpret beta:
- Beta equals 1.0 – The magnitude of stock price movements is identical to the underlying index movement
- Beta is less than 1.0 – The magnitude of stock price movements is weaker than the underlying index movement
- Beta is greater than 1.0 – The magnitude of the stock price movements is greater than the underlying index movement
- Beta is negative – This is less common, but a negative value means the stock price movements are opposite to the underlying index movement
Let’s look at some examples.
A stock has a beta of 1.5. That means when the index rises or falls by 1%, the stock, on average, has historically moved in the same direction, by 1.5%.
A stock has a beta of 0.8. That means when the index rises or falls by 1%, the stock, on average, has historically moved in the same direction, by 0.8%.
A stock has a beta of -2.5. That means when the index rises or falls by 1%, the stock, on average, has historically moved by 2.5% in the opposite direction.
What causes market volatility?
There are countless factors influencing the movement in share prices. But at the core, it all boils down to one thing – uncertainty.
Younger companies tend to be more volatile than large blue-chip stocks because there is a greater chance of failure. But that doesn’t mean industry titans are immune to sudden price movements. An outstanding or terrible earnings report can send a stock surging or plummeting regardless of market capitalisation.
Beyond the underlying business performance, there are macroeconomic and geopolitical factors influencing the financial market. If the economy starts underperforming, then chances are businesses will struggle to maintain or increase growth, resulting in missed earnings targets.
At the same time, if political tensions between nations start to mount, it can create major disruptions. Just look at the tragic situation in Ukraine, or the regulatory disputes between the US and China.
What is causing our current stock market volatility?
2022 has been a tough year for investors so far. But what’s behind all the volatility in the market? It’s the same thing we have just discussed – uncertainty, specifically in the macroeconomic picture rather than individual businesses.
During the height of the pandemic in 2020, stimulus cheques were issued to keep the economy running and help those who were unable to work during lockdowns. However, giving large amounts of money to populations worldwide has unsurprisingly led to a considerable rise in inflation. And this has only been amplified by Covid-triggered supply shortages that continue to pose a problem today.
To combat this the Bank of England has begun raising interest rates. This makes corporate and personal debt more expensive but helps pull money out of the economy, bringing inflation down.
That’s bad news for debt-ridden companies with limited cash flows since interest bills will go up. And as for consumers, mortgages are also getting more expensive.
Meanwhile, a conflict in Eastern Europe has further disrupted supply chains. And with sanctions placed on Russia, oil & gas prices have gone through the roof. Consequently, energy bills are skyrocketing, putting further pressure on consumer spending power, leading to an economic slowdown.
And with further interest rate hikes on the horizon to combat inflation, there are rising fears that another recession is on its way.
With that in mind, the high volatility we’re currently experiencing starts to make a lot of sense. Fortunately, investors are not powerless in defending their investments.
How to deal with market volatility
1. Think long term
Stock prices can’t continue going up forever. There will be prolonged periods of price declines as many new investors are starting to discover. And it will undoubtedly happen again at some point in the future.
But it’s important to keep things in perspective. Periods of high stock market volatility are always temporary.
The stock market has been around since the late 1700s. Since then, there have been plenty of economic disasters, wars, trade disputes, recessions, supply shortages, 30% inflation, sky-high interest rates, and other countless factors resulting in share price crashes. Yet, the stock market has a 100% recovery success rate.
No one knows when the current stock market decline will end. But we do know that it eventually will and then continue to grow to new heights over the long term.
2. Buy the dip
Plenty of stock prices have collapsed in recent months, especially in high-growth sectors like technology. But that doesn’t mean the underlying business is compromised. In fact, chances are a once-in-a-decade buying opportunity just emerged.
Take a look at Apple during the 2008 financial crisis. The stock collapsed by over 50% within 12 months despite having no direct link to the housing sector. And even with the subsequent recession, the share price made a full recovery within 10 months and continued to climb over 1,900% to today’s price.
Seek to use the current volatile market as an opportunity to buy shares in strong businesses that can continue to thrive in the long term.
3. Diversify your portfolio
Diversification is a powerful risk-reduction tool that, when used correctly, can mitigate some of the impact caused by stock market volatility.
Different sectors are being affected in different ways in the current economic climate. Resource companies like mining and oil stocks are actually thriving thanks to the elevated commodity prices. Rising interest rates also create a favourable lending environment for bank stocks. But the same can’t be said for other sectors like technology, e-commerce, or fintech.
By owning a diverse portfolio of companies in various industries, the adverse impact of stock market volatility can be mitigated.
Takeaway
Market volatility is inevitable. It’s just part of the risk you take on when you start your investing journey.
The investment strategy that will serve you well is to remember that investing is a long-term game, and you’re not at the finish line yet. Even if investor sentiment is low, you’re already ahead by playing the game at all.
So keep your head up and hold on.