April 02, 2021
Over the last year, investors have been treated to eye-watering growth in the price of stocks. However, that growth didn’t come without a price. The COVID-19 pandemic caused unprecedented economic, social, and political disruption. These factors contributed to aggressive ups-and-downs in stock prices throughout 2020 and early 2021. These ups-and-downs have a more technical name: volatility.
What is volatility?
Volatility is a characteristic of stocks and other financial instruments. Stocks exhibiting low volatility will see the price trade tightly against the average price over a period of time. Stocks exhibiting high volatility will see trade “all over the place” relative to the average price over a period of time. The movement against the average (mean) price is usually measured in terms of standard deviation.
If you don’t want to bother doing the math yourself, you can measure volatility using a metric called beta, which gauges the individual short-term risk that a stock carries in relation to the broader market. Index strategies like the S&P 500 have a beta of 1.0. If a stock has a beta greater than 1.0 (higher than the index), this means the stock is more volatile than the broader market. If the stock has a beta less than 1.0, it means the stock has lower volatility.
So what does this mean in practice for investors? Well, say that you are considering two similar stocks in the same industry. Let’s also assume they have similar prices. If one has a higher beta, you can expect the stock to move more aggressively in the short-term. This means that the stock might dip or rise over a shorter period of time than another stock with a lower beta. Some investors might find this volatility enticing because it can enable different trading strategies, like swing-trading, straddle options, etc.
What causes volatility and what does it do to stocks?
Volatility can be caused by a large number of factors. These factors can be social, economic, political, or a cross-section of two or all of these factors.
Some volatility can be related to social factors. Take, for instance, the volatility in the January 2021 GameStop short squeeze. A mix of social and financial factors prompted shares of GameStop and other “meme stocks” to take off. Volatility was caused in part by shorts (people betting against the stocks), social interest in the stocks on social media, and the relationship between option ladders and stock prices. This provides some evidence that not all volatility has to be related to a “crash” or world-changing event.
Some volatility can be related to changes in the economy or politics. Perhaps a key indicator, like unemployment, underperforms in a given period compared to what analysts anticipated. This might prompt stocks to move based on the miss or beat. At a 30,000-foot view, a change to a government’s fiscal policy or monetary policy could move markets as well. Fiscal policy refers to taxation or government spending. Monetary policy refers to interest rates and the printing of money. For example, as rates began to rise for the first time since the COVID-19 pandemic, markets started to dip in response throughout February 2021. When rates reversed in early March 2021, markets swiftly recovered in response.
Every once in a while, a mix of factors can send markets into a flurry. Take the COVID-19 pandemic, which blended a mix of all of these factors. During this period, volatility was more pronounced in the broader market. On some days during the crash, markets would fall as much as 12%. Within a few days, those same down markets would climb as much as 9%. Some stocks, which were more affected by the pandemic, were made to weather more volatility than others.
All-in-all, volatility is generally influenced by events in the market. Since markets offer a window into economies, they reflect the temperamentality that investors feel. This is also one reason why some countries’ stock markets might experience more volatility than others on given days. One event might affect a country much different than another. In the same sense, one event might disproportionately benefit or hurt one industry or sector versus another.
What should investors do about volatility?
The best way for long-term investors to weather volatility is to stay the course. Volatility can benefit you (i.e: make your stocks go up), offering you an opportunity to sell if you are willing to bet the stock will drop and allow you to enter at a lower price. On the flip side, volatility can hurt you (i.e: make your stocks go down). A fatal mistake that many investors make is throwing out investments that still have juice in them. This is why it’s important to know the stocks and indexes you own, be prepared for volatility or dramatic market moves, and stay the course.
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