What is Market Volatility?

Market volatility defined

Market volatility reflects the constant movement up and down (and back again) of investments. To be more technical, it’s a measure of how consistently an investment or index has performed—or not—compared with either a benchmark or its own average. It can refer to a single investment, like a particular stock, or an entire market. In essence, it’s a totally normal part of investing.

Is market volatility a good or a bad thing?

Market volatility often gets a bad rap, which can be understandable. After all, the roller-coaster ride that is the stock market can be pretty scary for the faint of heart and many novice investors. And when you start hearing about how volatile the market is in the news, it’s usually when volatility is high, which, pundits warn, may be a harbinger for a bear market, or a period when major indexes drop by 20 percent or more. That’s what happened recently, when the longest bull market in history transitioned to a bear market after concerns about the economic impact of the coronavirus brought major market indexes down 20 percent from recent highs.

But market volatility has a good side, too. One bright spot is obvious: Sometimes extreme spikes are in the upward direction, not downward toward bear market territory. And if you’re invested in the market, and stocks go on a tear, you’d be happy for the spike in prices.

On the flip side, when stock prices drop, there’s also a silver lining: It creates a good buying opportunity for anyone who believes certain picks are bound to bounce back. (And the market has always bounced back from downturns.)

The truth is that a normal level of market volatility can be both good and bad. It’s the very heart of investing, keeping everyone’s money moving and giving investors a chance to make good on the classic investing directive to buy low and sell high.

How is market volatility measured?

You can look back at how prices have swung from month to month, day to day, or even minute to minute to gauge market volatility. Experts often focus on the monthly returns of the Standard & Poor (S&P) 500 stock index (often used as a proxy for the whole U.S. stock market) and calculate how much each month’s return differed from the year’s average monthly return. That difference is called the standard deviation, a commonly used measure of volatility.

Another way is to focus on daily price movements. A big change in the value of the S&P 500—notably higher or lower than the average 0.66 percent daily move, according to data from Adviser Investments—on any given day is likely to make headlines. And experts frequently point to how many days major indexes experience significant swings in a given period as yet another measure of market volatility. For example, the S&P’s value changes by 1 percent or more 52 days of the year, on average. Much greater frequency than that means extra volatility.

All of those methods reflect historical market volatility. If you’d rather look forward, future volatility (also called “implied volatility”) is estimated by the Chicago Board Options Exchange’s Volatility Index, aka the VIX. It’s also known as the investor fear gauge. It measures how the S&P 500 is expected to perform over the next 30 days, based on put and call options. Put and call options are investors’ agreements to, respectively, sell and buy investments at specified prices on or before a particular date. (But they’re not binding, i.e., ordering a put option gives you the chance to sell, but does not require you to do it.) When the VIX is rising, market volatility is rising.

What’s a normal amount of market volatility?

Historically, the S&P 500’s long-term average standard deviation has been 15.6 percent, according to Adviser Investments. And in recent years, it has been decidedly below average. For example, in 2017, standard deviation went as low as 6.7 percent, the second-lowest level since 1957. (The lowest year on record was 1963 when standard deviation was just about 5 percent.) And the S&P moved by 1 percent or more on only nine trading days that year. So in 2018, when market volatility returned to the historic average, those “normal” levels were jarring to many investors.

Why is market volatility rising, and should investors be worried?

Uncertainty, in general, is a major cause for market volatility, and the current climate is rife with it. From the coronavirus to The Fed’s decisions on interest rates to the upcoming presidential election, huge question marks on what the future holds are keeping investors on their toes and the stock market churning.

It’s understandable to be concerned about rising market volatility. If volatility is high for a stock, that means it could be a risky bet because of wild price swings. And if volatility is high for the overall market, get ready to swoon (and not in a celebrity-sighting kind of way): Experts often point to high market volatility as an indicator that a big drop and potential bear market is on the way. In fact, the stock market’s recent foray into bear market territory is in part because of all of the volatility and uncertainty surrounding the coronavirus.

This lines up with what history shows: When the VIX is on the rise, the S&P 500 index typically falls. And higher levels of volatility tend to indicate greater short-term losses. What’s important to remember, though, is what else history reveals. After each of these periods of increased volatility and losses, the stock market has rebounded to unprecedented heights.

What does all of this mean for investors?

It means that investors need to take into account market volatility when making long-term investing plans. That doesn’t mean you should be feverishly checking the market’s daily price swings and reacting accordingly, day in and day out. It’s more like how you plan for traffic along your morning commute: You know it’s coming because that’s just life—so you have to bake it into your schedule and leave with extra time to spare.

Same goes for volatility and your investing strategy. While volatility can seem game-changing, it’s totally normal. So no amount of it should send you into a panic or veer you off course. You should already expect it when you build your portfolio, making sure your investments are diversified enough to withstand all the ups and downs the market is bound to throw at you. (Acorns portfolios include funds with exposure to thousands of stocks and bonds. You can start investing for as little as $5.) That way you know you’ll be ready, no matter what happens next. And market volatility can simply offer you opportunities to buy low, sell high, and realize all your financial dreams.