It is never a good idea to feel rushed into an investment just because the market is bearish, or that there are signs of it becoming bullish. Good investing requires you to adjust your strategy in response to market changes.
But when you are just starting out as an investor, it can be difficult to figure out what your next move should be.
What is a volatile market?
Volatility describes a market situation of unpredictable, and sometimes sharp, rise and falls. Volatility is inevitable in a healthy market, and every long-term investor will experience it on their investing journey.
What causes volatility?
Fluctuations in the market can be affected by various circumstances and factors, both internal and external.
Political and economic factors
Governments help regulate industries, and this can impact an economy when they make decisions on agreements and policies. From speeches to elections and laws, these can cause reactions among investors, which influence share prices.
Economic reports also play a role; when the economy is doing well, investors tend to react positively, making prices go up because they raise demand to buy. These sentiments also tend to come after positive quarterly employment data, inflation rates, consumer spending figures and GDP calculations.
Industry and sector factors
Specific events can cause volatility within an industry or sector. In the oil sector, for example, a major weather event in an important oil-producing area can cause oil prices to increase, as supply gets threatened.
As a result, the share price of oil distribution-related companies may rise, as they would be expected to benefit, while the prices of those that have high oil costs within their business may fall.
Similarly, more government regulation in a specific industry could result in stock prices falling, due to increased compliance and employee costs that may impact future earnings growth.
Looking inward, volatility can also be attributed to an individual company’s performance.
Positive news, such as a strong earnings report or a new product that is flying off the shelves can make investors feel good about the business. If many investors look to buy it, this increased demand can help to raise the share price sharply.
In contrast, a product recall, data breach or management scandals can all hurt a share price, as investors sell off their shares. Depending on how large the company is, this positive or negative performance can also have an impact on the broader market.
How volatility is measured
Volatility can be measured using two different methods. The first is based on performing calculations on the historical prices over a specific period.
The second method to measure volatility involves inferring its value based on their current prices.
Both methods seek to find the standard deviation of price changes over a period.
These methods seek to find the standard deviation of price changes over a period.
Standard deviations are important because not only do they tell you how much a value may change, but they also provide a guide for the odds it will happen.
Traders calculate standard deviations of market values based on end-of-day trading values, changes to values within a trading session—intraday volatility—or projected future changes in values.
Casual market watchers are probably most familiar with that last method, which is used by the Chicago Board Options Exchange’s Volatility Index, commonly referred to as the VIX.
What is the VIX?
The VIX —also known as the “fear index”— is the most well-known measure of stock market volatility. This real-time index gauges investors’ expectations about the movement of stock prices over the next 30 days based on S&P 500 options trading.
The VIX charts how much traders expect S&P 500 prices to change, up or down, in the next month.
Rule of thumb: The higher the VIX, the more expensive the options.
5 ways to manage volatility in your investments:
1. Diversify your portfolio
A well-diversified portfolio containing a broad mix of equities, bonds and cash will likely be less volatile over the long term than a portfolio concentrated in only a few investments.
In a well-diversified portfolio, losses in one area tend to be offset with gains in other areas. If you want to mitigate the level of volatility in your portfolio, diversification is one of the keys.
2. Try dollar-cost averaging
Dollar-cost averaging is where you regularly purchase a predetermined dollar amount of a certain security.
(Read more: What Exactly is Dollar-Cost Averaging?)
For example, you might invest $100 in a stock every week or $500 every two weeks. If you automate your contributions, you can do this without even thinking about it. No need to worry about whether prices are heading up or down, because this mechanical process eliminates emotion.
You’ll naturally buy more when prices are lower, and less when prices are higher.
3. Consider market volatility an opportunity
It may help you deal emotionally and mentally with market volatility to think about how much stock you can purchase while the market is in a bearish downward state.
The natural ebbs and flows of market prices, and the crowd’s fear or greed, can generate opportunities if you take a rational, disciplined approach.
4. Be aware of your biases
It is important to remember that market volatility is the natural result of the relentless tug-of-war between bulls and bears and that investing entails assuming some degree of risk. Consider tweaking your holdings but think twice before making major shifts.
Keep your emotions in check and remember that overcoming behavioural biases at either the highs or the lows of the market is pivotal in making wise investment decisions.
5. Remember your long-term plan
Investing is a long-haul game, and a well-balanced, diversified portfolio was built with ups-and-downs in mind.
If you need your funds soon, they should not be in the market, where volatility can affect your ability to get them out in a hurry.
If you need your funds soon, they should not be in the market
But for long-term goals, volatility is part of the ride to significant growth. Focus on your goals and don’t let short-term volatility derail your long-term investment plans.
The Bottom Line on Market Volatility
It is perfectly normal to be concerned by periods of market volatility. Hell, it can even be scary to see large—or even small—losses on paper.
But in the end, you must remember that market volatility is part and parcel of investing and the companies you invest in will respond to a crisis. You cannot altogether avoid volatility during your investing journey, but portfolio diversification and other investment strategies allow you to use it to your advantage to weather the storms and ride the highs.