Volatility in the stock market: what it means and how to manage it

The stock market is in constant flux with different indexes experiencing gains and losses each trading day. More recently, even during relatively calm periods, the S&P 500 will still go up and down by less than 1%.¹ While these changes aren’t always dramatic, there are times when the stock market will take you on a roller coaster of highs and lows – a phenomenon known as “volatility.”

Of course, the pandemic was a prime example of high volatility, but more recently, we saw a week of price swings following the closures of Silicon Valley Bank and Signature Bank.² Volatile market events can be rattling for any investor – especially when there’s a bear market. But they are also inevitable.

So, how can you develop an investment strategy that can not only weather these storms but potentially take advantage of rapid stock price changes?

Before we dive into strategy, it’s important to understand what stock market volatility really means. “Dramatic gains and losses” is a decent descriptor, but volatility is also a measure of the frequency and scale of stock price swings. For instance, high volatility is when stock values continue to fluctuate by greater than 1% per day for a prolonged time.³ On the other hand, a period of low volatility may be characterized by infrequent and insubstantial changes.

Generally, greater volatility carries more risk to the investor; but – unless you want to divest all your wealth into CDs, cash or money market funds – managing it isn’t about avoidance. Instead, it’s about choosing an investment strategy with the right level of volatility that can help:

●      Weather a market decline without exposing you to too much risk

●      Deliver long-term return potential to help you meet your financial goal

Historical volatility uses the standard deviation in price swings over time to determine the likelihood of a stock drifting away from the average price. Calculations are usually based on changes between each closing price, but they can also include fluctuations that occur during the trading day. Generally, they gauge volatility on time scales ranging from a week to a year

When historical volatility is high, the stock price is expected to fluctuate more significantly and with greater frequency. In contrast, when this metric is low, it implies the company has mitigated uncertainty and is returning to a stable period.⁴ 

Stock market volatility is often measured using the standard deviation of stock market index price changes over time. Portfolios with a higher standard deviation tend to be more volatile and may have greater movement up or down.

As a reflection of the way investors currently feel about the market, volatility represents uncertainty, not necessarily pessimism. While you can’t be inside the head of each investor, you still need to understand how economic and political changes and events might impact sentiment. For instance, during times of rising interest rates or political instability, you may see increased volatility in the financial market.

Sometimes there can be excessive volatility in the same day. If stock in a company jumps say 20% in a single day, you might not be worried. However, when markets become especially turbulent, the exchanges might step in to put a trading curb in place. This stops market participants from trading for a given period of time – up to a day in some cases – allowing things to cool off and stabilize. But what might cause volatility to get that high?

Starting off small, business performance can be a key driver of volatility in stocks. When a company outperforms expectations, investors often want to buy in, which may increase the stock price. On the other hand, if a business experiences a significant problem – either with its products, services or people – it can worry shareholders, causing them to sell off en masse. In the case of large enterprises, these fluctuations can have far-reaching effects on much broader markets.

On a broader scale, events within a specific market, like supply chain disruption, can have huge effects on volatility. For example, when the pandemic led to a global chip shortage, auto manufacturers were unable to meet demands and the industry experienced a period of high volatility that actually bumped chipmakers’ stock prices up eventually.⁵ In general, incidents like supply disruptions, natural disasters, bankruptcies and government regulations can cause market volatility for impacted industries.

Zooming out further, the economy plays a big role in market volatility. When the economy is doing particularly well, investors might even see a bull market where prices continue to rise. Conversely, factors like GDP, consumer spending or inflation can cause a sharp decline in the market. In either case, the economy experiences volatility with both positive and negative effects.

Finally, governments making decisions around policies, trade agreements and regulations can have some of the largest impacts on the financial market. But it’s not just legislation that can cause volatility. Investor behavior can change from anything, including speeches and elections – as we saw in 2020. On the extreme end, we can look at the Russian invasion of Ukraine, which caused the price of commodities like grain to rise dramatically. The war has also caused a boost in defense stocks with more countries already increasing or expected to grow their military spending for the foreseeable future – another example of politically driven volatility.⁶

While volatility and risk are closely related, they aren’t interchangeable terms.

Whereas volatility measures the frequency and magnitude of price swings, risk represents a wide variety of factors that can be measured in many ways. Of course, all investments have risk – some more than others. High volatility often coincides with increased risk, but this isn’t always a drawback. And it may be the case that stock markets aren’t experiencing significant price volatility, but that doesn’t mean there’s no risk of unforeseen swings when economic or political news arrives.

High volatility doesn’t always equal high risk. Similarly, a volatile period doesn’t necessarily equate to downside risk. Downside risk refers to the potential for negative or unfavorable outcomes in a market, but upside risk measures the uncertain possibility of potential gains.

Just as risk isn’t necessarily a bad thing, neither is volatility. In fact, it can open the door to plenty of new investing opportunities. For example, a bear market can offer you the chance to purchase additional stocks at a lower price for companies you believe will outperform in the long run. During a bull market, you can do the opposite, selling off high-performing stocks to reinvest in other areas. It all depends on the type of investor you are and your tolerance for risk.

Ultimately, how you react to and manage volatility in your portfolio will depend on a number of personal factors that guide your investment strategy. But trying to make adjustments to your portfolio to outguess or time market volatility isn’t a good investment tactic.

Even experts like mutual fund managers and other financial professionals can’t successfully do this on a consistent basis. Remember that downturns will come and go in investing, and past performance won’t guarantee future results, but both stocks and bonds have historically performed well over the long run.

Next time volatility in the stock market has you questioning your investment strategy, try one of these tips: