October 27, 2022
Over the last few months, investors have witnessed sudden ups and downs in the stock market almost overnight. We saw last week’s tech-heavy Nasdaq plunge, then only a couple of days later it finished in the green. How can we navigate this apparently turbulent sea of charts, news and predictions?
The COVID-19 pandemic caused unprecedented economic, social, and political disruption. Money printed abounded, unbalancing inflation. This week, the Fed is currently meeting to discuss interest rate hikes. These factors contributed to aggressive ups and downs in stock prices throughout 2020 and 2021. These ups-and-downs have a more technical name: volatility.
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What is volatility?
Volatility is an attribute 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 (AKA a method to define the relative riskiness of an asset).
If you can’t be bothered 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.
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.
How to deal with volatility?
One way for long-term investors to weather volatility is to stay the course. Volatility might 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 could hurt you (i.e: make your stocks go down). A 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.
In the case you need help seeking stocks to weather uncertain times, you might want to check out the Front app. Front helps retail investors make more confident investing decisions. Front is powered by robust AI-driven stock scoring, which helps investors gauge the “fit” of an investment by peering into stock performance, news, and balance sheets. It does the heavy lifting, so you can focus on finding stocks worth investing in.