Market Volatility: The Basics
Volatility is an ideal that has been present in markets for a very long time.
It is a statistical measure that has been analyzed keenly by key players in the market. It refers to the dispersion of returns for a certain stock or index. The standard measurements used to measure volatility in its basic form are standard deviation and variance.
Another perspective would be that market volatility is the fluctuation of stock prices. A state of low volatility means that there are small fluctuations in the market whereas the state of high volatility means that there are large fluctuations.
The markets here could either be stocks, bonds, commodities, or currencies. Their movements, on the other hand, are considered to be either be upward, downward or sideways. In financial lingo, these movements are called bull markets, bear markets, and range-bound markets respectively.
Volatility measures the uncertainty or risk that’s brought about by changes in the value of a security. When you hear such statements such as high volatility, it basically means that the price of a security is likely to change abruptly in any direction over a short period of time. On the other hand, low volatility signifies that the price of the security is likely to change, but not as abruptly. It will change steadily and over time.
A number of measures are used to measure the volatility of a stock. The popular measure is using the stock beta. With the beta measure, volatility is determined by comparing the total returns of the security in question with a relevant base point. Normally the S&P 500 is used as the benchmark.
When you have invested in a highly volatile market, there are some strategies you can employ to counteract this volatility.
Diversification of Portfolio
This entails spreading your investments across various assets in the market. You can invest in stocks, bonds, and cash assets all at the same time.
The underlying reason for this is spreading out the risk over a broad class of assets so that in the event of loss, the loss of one asset can be offset by the gains in another asset.
This strategy is an effective way of managing investment risk. It typically embodies the practical sense of not putting your eggs in one basket lest you lose them all when the basket falls.
Carrying Out Due Diligence
The importance of due diligence in the securities market cannot be overemphasized. If need be, consult a financial adviser. In order to effectively determine whether the market is volatile, a lot of research and analyses have to be carried out.
In normal circumstances, it’s quite hard for one to individually carry out an extensive due diligence on their own without the input of professionals. Therefore, it is essential that you utilize the input of research analysts, financial strategists, and economists.
They are well versed and competent in these respects. Always be on the lookout for their publications and press releases.
Volatility Responsive Asset Allocation (VRAA)
To tackle market volatility, an approach known as the Volatility Responsive Asset Allocation is employed by medium and high-risk investors. The approach is responsive to specific signals that denote changes in market volatility.
When the signal indicates a drop from a high volatility level to a much lower one:
- Investors switch their low-risk portfolios to medium risk portfolios while their medium risk portfolios are switched to high-risk portfolios.
When the signal denotes a change from low levels of volatility to high levels:
- Medium risk portfolios are switched to low-risk allocations while high-risk portfolios are assigned medium risk allocation.
The resultant effect is that the total return on investment is much higher and the overall investment is much safer.
Market volatility, though, is not easily predictable. Moreover, the predictions that are out there are not accurate per se. Even so, they provide a rational and logical explanation of matters.
The norm is that when there is high market volatility, investors respond by decreasing the market risk of their portfolios. On the other hand, when there is low volatility, investors take on more risk.
In conclusion, it is up to an investor to understand market volatility specifically in their niche market of investment. This will ensure that they effectively and efficiently improve their return on investments amidst market volatility.