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Originally Posted On: https://www.kellettschaffner.com/library/what-is-volatility-in-the-stock-market

 

In the US, there have been 6 major stock market crashes where the market lost more than ten percent of its value. All these crashes were followed by recoveries, although some of them took longer than others to occur.

If you invest in stocks, you understand how unpredictable prices can be. Price fluctuations due to external events can affect the value of your portfolio but there are other factors at play. Here’s what you should know about volatility in the stock market.

Thoughts on Market Volatility

Volatility measures the size of price swings, not the direction of the movement in prices. Stock market volatility occurs when the market average moves up or down more than usual. This is usually measured using stock indexes.

Individual stocks can be volatile as well, and some sectors are more affected than others. There are opportunities in a volatile market even though investing in stocks during uncertain times can be riskier.

The Efficient Market Theory

In the past, analysts felt the stock market had access to all available information which made the market efficient. A stock price should reflect the value of the underlying asset or the company you are measuring. The calculation is the present value of future cash flows of the company.

The efficient market hypothesis said it would be difficult for an investor to beat the market average. It also assumed that people would act with logic instead of allowing their emotions to influence their decisions.

Markets aren’t as rational or efficient as we used to think. Investor biases have an impact on the market as they trade and their emotions come into play as well.

The Fear Factor

World events can disrupt our way of living and create uncertainty in the markets. When stock prices react to news of shortages or shipping delays, fear rises as well and some investors react by selling their stock. Buyers turn into sellers and that feeds a further drop in prices.

Bear markets are a time of falling prices and they tend to provoke fear in many investors. Some say a bear market represents volatility. If you understand the cause of a drop in the market, you may see it as an opportunity to buy high-value stocks at a lower price.

Other Impacts on Volatility

The monetary policies of governments can have a large impact on the volatility of stock markets. Concerns over tighter monetary policy by the Federal Reserve can cause drops in the market.

Gross domestic product (GDP) and inflation are two economic conditions that can affect markets as well. Most of these are external influences that you can’t control.

How Restricted Funds Affect Volatility

There’s another theory about the market called the inelastic markets hypothesis. A lot of money in the market is in funds such as retirement pension funds and mutual funds. These funds have mandates that restrict their holdings.

Most of the money isn’t traded actively. This money is sitting on the sidelines, so it’s considered inelastic. When active traders enter the market their actions have a greater effect on prices due to these restricted funds.

They are smaller in number and control less money. A small number of traders can have a large influence on the market. It’s estimated that their influence is five times more powerful this way.

Investor Demand and Volatility

When demand for products or services slows, that creates uncertainty in the market and prices may drop. When demand increases, products become scarce and prices can increase. We all remember the high demand for toilet paper at the start of the pandemic.

Consumer demand is sometimes irrational as people act before they have the information they need to make a good decision. You can measure demand as the increase in money flowing into the stock market. Many of our financial models don’t consider supply and demand in their calculations.

Approaches to Market Volatility

Markets can be unpredictable and any investor knows how unnerving volatility can be. It’s hard to resist taking action when the market is sliding so it’s good to have an investment plan to follow. When creating your plan, there are some steps you can take to reduce the impact of market volatility.

Diversify According to Your Risk Tolerance

Plan your portfolio to hold assets across a wide variety of sectors, types of financial instruments, and categories. This spreads your risk around, which reduces portfolio risk.

If you have the advantage of time, your risk tolerance may be higher. When you are closer to retirement age, your portfolio diversification needs to change. It’s more difficult to recover from market volatility in retirement because you are on a fixed income and don’t have the same opportunities to recover investment losses.

Long-term Investing and Volatility

If you are a day trader, buying and selling stocks daily in an attempt to time the market, volatility plays an important role in your decisions. Long-term investors tend to ignore market volatility over the short term.

Daily price movements do not affect an investor who isn’t considering selling. They look at risks to a company’s future growth instead and ignore these short-term changes in asset price.

Timing the Market Is Futile

It’s difficult to stick to your plan when markets are dropping but it’s the best approach you can take. A drop in market prices isn’t a reason to buy anything, but there may be some opportunities if you’ve done your research. Look for quality stocks with a proven track record and low debt.

When you see high-value stocks drop in a volatile market, it’s likely that the underlying assets in the company are still solid. The stock is trading at a sale price and it may be a good time to invest.

Understanding Volatility in the Stock Market

When it comes to your future, you can prepare for volatility in the stock market by creating an investment plan. Our experienced team will take the time to work with you to build a road map to success.

No matter where you are in your life, Kellett Schaffner Wealth Advisors is ready to give you the knowledge you need to achieve financial confidence.