Risk Management

What's Market Volatility, and how can it help you?

October 26, 2022
4 min

The term "volatility" is often thrown around when talking about the financial markets, albeit in negative ways.

Prices go up and down daily, and this uncertainty can be frightening to many investors.

Market volatility, however, is not always bad. Whether you are an investor who is a risk-taker or risk-averse, knowing your way around market volatility will help you craft your winning investment strategy in the financial markets.

What do we mean by Market Volatility?

Market volatility measures how much asset prices fluctuate over time. It concerns how quickly, how often, and how much the price changes. The sharper and more frequent the price movements are, the more volatile the market is.

Market volatility is typically associated with fear, which surges during bear markets, recessions, and stock market crashes.

So, why does market volatility matter to you? 

Because, although it can be frightening and discourage one from investing their capital, a volatile market can offer high opportunities (at the price of higher risk).

If your time horizon is long and your portfolio's asset mix is well diversified, you can even consider waiting for the turbulence to pass. However, a clearer picture of the market conditions can help you understand the current risks and give you the opportunity to rebalance your portfolio.

If, on the other hand, you are prone to risk (and skilled), one way to secure your investments from unrealized gains or potential losses can be to exploit the market bottom.

What causes Market Volatility?

Market volatility is generated by many factors, including spiking interest rates, geopolitical conditions, and natural disasters, among other reasons. 

Know that when uncertain external events occur, it is usually followed by stock market volatility. It induces fear among investors and sets off spikes in market activity.

For example, at the beginning of the COVID-19 pandemic, the DOW Jones lost 37% of its value in a month. No one knew what would happen, and this uncertainty resulted in investors to panic buying and selling their stocks.

How's volatility measured? 

Market volatility is computed as a function of the standard deviation and the time horizon an asset is being analyzed. The standard deviation measures how much a price changes from its average value over time. It also provides a framework that predicts the likelihood of this change.

Investors interested in the volatility of an individual asset as compared to the overall market often use the beta.

A beta of 1.0 indicates that the asset and the market are moving in tandem. Below this threshold, the asset is less volatile than the market, while above it indicates greater volatility and potentially greater risk.

Market Volatility vs Market Risk

Market volatility and market risk are interrelated concepts but don't get them mixed up.

True. A period of high volatility can carry significant risks to the stability of a portfolio. However, volatility is a crucial component of financial markets and does not necessarily imply the possibility of not recovering from losses incurred.

Data source: Bloomberg Finance.

Bitcoin is a great example. Its exponential growth is not linear. Indeed, its performance is highly susceptible to market sentiment and can abruptly vary daily or alternate between rapid growth and an equally significant drop.

This creates risks related to the timing and amount purchased.

However, many consider Bitcoin a sound long-term investment, given its progressive adoption and current capitalization.

Consequently, its volatility can be an appealing factor, especially for short-term traders, while the risk associated with a loss with no chance of recovery is considered very unlikely.

So, is Volatility a good thing?

Working with financial markets volatility can be tricky, but if you play your cards right, it can be a great friend during uncertain times. Wider-than-normal intraday price fluctuations enable the most competent traders to generate the highest returns, exploiting the earlier low prices and the subsequent market recovery.

Case in point, at the beginning of the bear market in March 2020, the S&P 500 index dropped to over 34% in value from its February peak but later fully rebounded by mid-August.

Source: cnbc.com

How You Can Be Profitable Amidst Market Volatility

There are no sure-fire ways to swing market volatility your way, but here are a few time-tested strategies that can help you manage your way around it.

Rely on solid businesses. 

Companies with good financial standing (low debt, high profitability, and positive cash flow) and a solid competitive advantage are more likely to weather market fluctuations. Look at blue-chip companies in the healthcare, food, and consumer staples sectors.

Consider more resilient assets.

Think of fixed-income securities like treasury bonds or corporate bonds and alternative assets like gold. Fixed-income securities provide you with regular cash returns via coupons, so even if your portfolio drops, you can reinvest this cash and lower the volatility of your portfolio. 

Meanwhile, gold has maintained its value over time as it is not impacted by interest rate movements or adverse economic events. Gold remains the same even if the dollar or stock markets go down. This makes it an excellent protection against market uncertainty. 

Think long-term. 

You are investing for the long haul. If you need your capital soon, it shouldn't be in the market in the first place. With this, keep in mind that volatility is a long-term investment cost. So long as you keep a well-balanced and diversified portfolio, don't stress yourself over any short-term market spikes. 

Rebalance your portfolio (if necessary). 

When market volatility shifts your asset allocation from what you have planned, rebalance your portfolio and align it back with your investment objectives and strategy. 

Sell some parts of the assets that significantly shifted your portfolio and use the returns to buy more of the reduced support. It is recommended to rebalance when your allocations drift by 5% or more from your initial portfolio planning.

Rely on other indicators to determine your moves.

Volatility alone is rarely the only indicator used to decide whether or not to move into the market. Experienced traders use a set of indicators to figure out when the chart indexes of a target asset are moving down or up.

Technology (AI, in particular) comes to the aid of investors in assessing the likelihood that a market movement will evolve into a trend.

That's also how Peccala trading engine work.

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