In the stock market, as in life, we must expect some volatility. But what exactly is volatility, and what do we need to know about it?
Often Used, Often Misunderstood
If you listen to the talking heads on financial television programs, sooner or later you’ll hear the term “volatility.” The thing is, they don’t bother to explain what this means, or how it can affect your stock portfolio. No worries, though – today I’ll break it down and make it understandable.
One Term, Many Definitions
You might hear statisticians define volatility in terms of “rate of increase or decrease,” “standard deviation of annualized returns,” or “measure of fluctuation”… none of which is helpful for most people. So, let’s see if we can simplify and clarify the term right now.
To put it in basic terms, volatility tells you how wildly a stock’s price moves. Big, fast, wild, sudden, and unpredictable moves are the signs of high volatility; stable, steady, and calm moves are the signs of low volatility.
Have you even been in a “volatile” relationship, with wild and unpredictable mood swings? That’s how some stocks behave. If you look at a stock chart and there are lots of big up and down movements, that’s what volatility looks like. In contrast, if the stock chart mostly sideways movement or gradual drifting with a mostly upward slope, that’s “complacency,” which is the opposite of volatility.
Up or Down… but Mostly Down
In the world of finance, simply calling a stock “volatile” doesn’t give an indication of whether the price is moving up or down at any given moment. Strictly speaking, a sharp move to the upside and a sharp move to the downside would both be considered volatile price action.
But then, we have to consider the often negative connotation that people, and particularly the media, assign to the term “volatile.” Thus, if you see someone wearing a suit on television and calling a particular stock or market sector “volatile,” he’s probably referring to its tendency to wipe out incautious investors’ accounts; if he’s calling the entire market volatile, he’s probably implying that panic is starting to set in.
Looking Back, or Looking Ahead?
Now is a good time to explain the difference between two types of volatility: historical and implied. Historical volatility refers to how big and wild the stock price’s movements were in the past, over a specified period of time. Implied volatility refers to how big and wild the stock price’s movements are expected to be in the future, over a specified period of time.
Assuming that no one knows for certain what will take place in the future, it’s reasonable to say that historical volatility is factual while implied volatility is an imperfect estimate. Textbooks tend to use one year as the look-back period for historical volatility as well as for the look-forward period for implied volatility, but the period can be adjusted to any amount of time.
Unfortunately, the aforementioned talking heads on financial news programs don’t always make it clear which type of volatility they’re referring to. And frankly, it’s possible that sometimes they don’t even know which type of volatility they’re talking about at any given moment.
Up, Down, and All Around
Okay, so now you can look at a chart and get a rough idea of whether a stock is volatilte or not. Still, keep in mind that volatility is a relative term, and is in the eye of the beholder: a conservative investor might consider a particular stock to be quite volatile, while a penny-stock day trader might look at that same stock and deem it not volatile at all.
Therefore, we can say that volatility means different things to different people, as wild movements might be distasteful to stability-minded investors (retirees sometimes fall into this category) but exciting to opportunistic and thrill-seeking traders.
If you’re financially and emotionally prepared for bigger and more frequent ups and downs, then you might be in a better position to handle the roller-coaster ride of highly volatile stocks. Otherwise, you’re probably better off sticking to safer, less volatile stocks.
Make Your Choice, and Stick to It
Highly volatile stocks are neither inherently good nor bad: they’re just “different,” in the same way a wild bronco is “different” from a well-trained horse. Whether you choose to invest in high-volatility or low-volatility stocks, your best bet is to choose the best volatility level for your individual needs and circumstances: make your choice and stick with it, for the sake of your sanity as well as your investments.