One of the most difficult things for investors to get used to is watching your investments go up and down. After looking at a particular company for weeks or months, you might be completely convinced that its prospects are limitless and its downside nonexistent. Yet as soon as you decide to put your hard-earned money into the stock, it suddenly decides to shoot down for no apparent reason.
While learning to deal with the volatility of stock prices is a challenge for everyone, it's important to recognize that volatility can also be a positive thing. While investing would be much easier if every stock moved up in a straight line, it wouldn't allow anyone to earn more than average returns from their investments. With volatility, however, you'll find unusual highs and lows that can provide you with the opportunity to earn extraordinary profits from stocks.
Although volatility is always present in the financial markets, it isn't constant. You've probably noticed that during some periods, the market doesn't seem to be very volatile at all. For instance, the past six months have been unusual not just because the stock market has moved sharply upward but also because it has risen without any significant temporary downturns along the way. A recent story at MarketWatch reminded investors that the Dow hasn't fallen more than 2% during this upswing, and neither the Dow nor the S&P 500 has suffered a 10% correction since 2003.
There's also a more direct way to measure the level of volatility in the markets. One indicator, known as the volatility index, or VIX, provides an explicit measure of volatility by looking at the price behavior of index options on the S&P 500. The VIX takes advantage of mathematical relationships among options prices, values and price movements of underlying stocks, and interest rates to calculate the implied volatility level. A high VIX level indicates that options traders believe prices are likely to move substantially in either direction over the next month, while a low VIX suggests greater price stability.
Nowhere to go but up
If you look at VIX figures since they were first calculated in 1990, you'll notice that the volatility in the market today is near its lowest levels in 10 years. In contrast, during the huge rise and fall of the stock market during the late 1990s and early 2000s, the VIX consistently remained at levels nearly double where they are currently. Some commentators believe that quiet periods represent the calm before an impending storm of volatility. However, since previous low levels of volatility during the 1990s persisted for years, it's difficult to pinpoint exactly when an explosive move upward in volatility will occur.
However, even during relatively quiet times in the markets, there are some brief periods when volatility shoots up suddenly. For instance, last May, the minor downturn in the major averages was accompanied by an increase in volatility, as the S&P 500 dropped nearly 8% in just a little more than a month. The VIX briefly doubled before falling back as the market rebounded in its latest advance. Furthermore, while a broad index may be stable, individual issues within that index can be extremely volatile. To see some recent examples, just take a look at the knocks that companies such as Overstock.com
Preparing for volatility
Even if you can't predict when the markets will become more volatile, you can still prepare for whenever it happens. The most important thing is not to become complacent about the amount of risk in your portfolio. When stocks rise substantially in smooth upward trends, it's easy to forget that equity securities are inherently risky and dependent on the continuing success of specific companies and the economy as a whole. However, a drop of 30%, which is far from unprecedented, would wipe out nearly all gains over the past four years. While a more modest correction may be more likely and would bring less substantial losses, you need to be mentally prepared for the worst.
In addition, if you haven't been rebalancing your portfolio on a regular basis, now is a good time to look at it. During times of rising stock prices and low volatility, the typical investor's portfolio can become overly weighted in stocks. By targeting specific percentages of your portfolio in each asset class, you can take advantage of high prices in stocks to sell at a profit and diversify into other assets, such as bonds and other fixed-income securities. Rebalancing isn't something you have to do every day, but if you've gone more than a year without looking at your portfolio allocation, you may be way out of balance with your targets.
Finally, low volatility means that options prices are relatively low. Although trading in options is risky and not something that many investors need to consider essential, relatively cheap prices make it more feasible to buy protective put options that will help you hedge against the risk of a market downturn. Conversely, it makes some strategies that rely on selling options, such as covered call strategies, less attractive, because you don't get as much money when you sell low-priced options.
Unless you stick with ultra-safe investments such as Treasury bills or bank CDs, volatility and investing go hand-in-hand. You can't eliminate volatility from your portfolio, but by being prepared for volatility when it comes, you can avoid the panic that causes many investors to make critical mistakes in response to unsettled times.
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Overstock is a former Rule Breakers pick.
Fool contributor Dan Caplinger remembers more volatile times, though the memories don't do justice to the reality. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy is stable.