Volatility: What Is It & What Is Its Impact On Investments?

Today’s infographic comes to us from Fisher Investments, and it serves as an introduction to the concept of volatility, along with offering a perspective on volatility’s impact on investments.

Technically speaking, volatility is a statistical measure of the dispersion of returns for a given security or market index over a specific timeframe. In other words, two stocks may have the same average rate of return over a year, but one may have daily moves of 1%, while the other may jump around by 5% each day. The latter stock has a higher standard deviation of returns, and thus has higher volatility.

Here’s what you need to know about standard deviation, which is a common measure of volatility:

• Roughly 68% of returns fall within +/-1 standard deviation
• To calculate standard deviation, differences must be squared. This means negative and positive differences are combined
• Standard deviation tells you how likely a particular value is, based on past data
• Standard deviation doesn’t, however, show you the direction of movement

This all gets more interesting as we look at the market as a whole, in which thousands of stocks (each with their own individual volatility) are moving up and down simultaneously.

Now that you can see how volatility plays out with individual stocks, it makes sense that market volatility is the overall volatility from the vast collection of stocks that make up the market.

In the United States, the most watched stock market index is the S&P 500 – a collection of 500 of the largest companies listed in the country. One measure of the volatility of the S&P 500 is the CBOE Volatility Index, or as it is known by its ticker symbol, the VIX.

Volatility and market sentiment in the overall market are important, because humans tend to experience the pain of loss more acutely than the upside of gains – and this can impact short-term decision making in the markets.

Negative price swings in the wider market can be distressful and unnerving for investors, and high volatility does present some challenges:

• Uncertainty in the markets can lead to fear, which can lead investors to make decisions they may otherwise not make
• If certain cashflows are needed at a later date, higher volatility means a greater chance of a shortfall
• Higher volatility also means a wider distribution of possible final portfolio values

That said, volatility also represents a chance of better returns than expected – and for long-term investors that are patient, volatility can help drive outcomes.