Stock market volatility represents the continual fluctuation of stock prices listed on stock market indices during a certain period of time. Stock market volatility is unpredictable, although several methods exist to measure it. The stock market experiences periods of high volatility, and at other times volatility is low. Investors must understand the causes of stock market volatility and how to limit risks during volatile times. Understanding volatility helps investors choose investments that increase their chances of profitability.
Measuring Stock Market Volatility
The CBOE Volatility Index is the primary method used to measure volatility. The VIX measures the movement of price options on the S&P 500 for 30 days. VIX is considered forward looking, giving investors an indication of the volatility of stocks in the future. Analysts and investors also measure stock market volatility using the standard deviation of a stock market index’s returns. Calculating standard deviation reveals if a stock market is experiencing high or low volatility. A disadvantage of using standard deviation is that it only looks at historical data. This is one reason why standard deviation is not used as often as the VIX.
Causes of Stock Market Volatility
Many factors can contribute to stock market volatility. Changes in the economy and world events are primary reasons for stock market volatility. For example, when the United State’s economy enters into a recession, the stock market fluctuates dramatically because investors are unsure of how long the recession will last and how much consumer spending will decrease. Other factors that influence volatility include political issues, taxes, wars and changes within an industry. Each factor affects the stock market in a different way, which may cause volatility to last a few weeks or much longer.
Reducing the Effects of Volatility
Stock market volatility is usually a short-term reaction to external factors affecting businesses. Asset allocation and diversification reduces the risk of losses to your stock portfolio due to volatility. It is uncommon for all types of investments to decline in value at the same time. Asset allocation involves investing in a variety of asset types, including stocks, bonds, mutual funds and real estate. Diversification involves investing in different asset classes, such as international, small-cap and large-cap stocks. Individuals can also invest in a variety of bonds, such as corporate and treasury bonds.
How Investors Should Respond
Some investors find it difficult to watch their portfolios decline in value during times of high volatility. As a result, some individuals choose to sell their investments when prices decline and attempt to buy investments when stocks are rebounding. This concept is called timing the market. Many investors who try to time the markets lose money because they buy investments after the price increases and sell investments after the price decreases. To avoid losing money, investors should develop long-term investment strategies that do not change because of volatility in the stock markets.
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