The stock market was "volatile" in the early days of the COVID-19 pandemic. It was "volatile" again, to a lesser degree, ahead of the 2020 U.S. presidential election. Maybe you've heard about the stock market's "fear gauge" being elevated at various times -- but what does that actually mean?
Here's what investors need to know about stock market volatility.
What is stock market volatility?
Stock market volatility is a measure of how much the stock market's overall value fluctuates up and down. Beyond the market as a whole, individual stocks can be considered volatile as well. More specifically, you can calculate volatility by looking at how much an asset's price varies from its average price. Standard deviation is the statistical measure commonly used to represent volatility.
Stock market volatility can pick up when external events create uncertainty. For example, while the major stock indices typically don't move by more than 1% in a single day, those indices routinely rose and fell by more than 5% each day during the beginning of the COVID-19 pandemic. No one knew what was going to happen, and that uncertainty led to frantic buying and selling. (Here's a linked resource if you'd like to explore research-based detail on how investors reacted to the volatility of 2020.)
Some stocks are more volatile than others. Shares of a large blue-chip company may not make very big price swings, while shares of a high-flying tech stock may do so often. That blue-chip stock is considered to have low volatility, while the tech stock has high volatility. Medium volatility is somewhere in between. An individual stock can also become more volatile around key events like quarterly earnings reports.
Volatility is often associated with fear, which tends to rise during bear markets, stock market crashes, and other big downward moves. However, volatility doesn't measure direction. It's simply a measure of how big the price swings are. You can think of volatility as a measure of short-term uncertainty.
Historical volatility is a measure of how volatile an asset was in the past, while implied volatility is a metric that represents how volatile investors expect an asset to be in the future. Implied volatility can be calculated from the prices of put and call options.
Beta and the VIX
For individual stocks, volatility is often encapsulated in a metric called beta. Beta measures a stock's historical volatility relative to the S&P 500 index.
A beta of more than one indicates that a stock has historically moved more than the S&P 500. For example, a stock with a beta of 1.2 could be expected to rise by 1.2% on average if the S&P rises by 1%. On the other hand, a beta of less than one implies a stock that is less reactive to overall market moves. And, finally, a negative beta (which is quite rare) tells investors that a stock tends to move in the opposite direction from the S&P 500.
For the entire stock market, the Chicago Board Options Exchange (CBOE) Volatility Index, known as the VIX, is a measure of the expected volatility over the next 30 days. The number itself isn't terribly important, and the actual calculation of the VIX is quite complex. However, it's important for investors to know that the VIX is often referred to as the market's "fear gauge." If the VIX rises significantly, investors could be worried about massive stock price movements in the days and weeks ahead.
Why is volatility important?
By understanding how volatility works, you can put yourself in a better position to understand the current stock market conditions as a whole, analyze the risk involved with any particular security, and construct a stock portfolio that is a great fit for your growth objectives and risk tolerance.
It's important to note, though, that volatility and risk are not the same thing. For stock traders who look to buy low and sell high every trading day, volatility and risk are deeply intertwined. Volatility also matters for those who may need to sell their stocks soon, such as those close to retirement. But for long-term investors who tend to hold stocks for many years, the day-to-day movements of those stocks hardly matters at all. Volatility is just noise when you allow your investments to compound long into the future.
Long-term investing still involves risks, but those risks are related to being wrong about a company's growth prospects or paying too high a price for that growth -- not volatility. Still, stock market volatility is an important concept with which all investors should be familiar.