The year 2020 will be remembered for a turbulent time on many fronts given Brexit, the Covid 19 Pandemic and the upcoming elections in the US to name a few. You will have heard of market volatility being referenced on most media outlets, but do you understand the basics of volatility? Read this article to find out
What is volatility?
Volatility is an investment term to describe when markets experience periods of unpredictable and sometimes sharp fluctuations in price. It is common to think of volatility in terms of price falls however it also refers to price rises too. Volatility is calculated over a specified period of time by measuring price movements. Statistically volatility is the standard deviation of a market or security’s annualised returns over a given time period i.e. it is the rate at which its price increases or decreases. High volatility is where the price fluctuates rapidly in a short period of time reaching new highs and lows, whereas low volatility is where the price moves higher or lower more slowly or stays relatively stable.
What causes volatility?
Volatility is caused by several factors some of which include the following
- Economic factors – any financial market is highly sensitive to major economic situations typically reacting negatively and in proportion to the size of the crises, the worse the crises the bigger its influence on overall market performance. Economic data such as monthly job reports, inflation data, consumer spending and GDP calculations also plays a role when affecting volatility. When the economy is doing well based on these metrics, investors tend to react positively and conversely if these metrics are lower than expected, markets may become more volatile.
- Political developments – Politics and Government policy are key factors affecting market performance. Everything between speeches to elections can cause reactions among investors which influences share prices. Governments make major decisions on trade agreements, taxes, tariffs and spending policy all which play a role in regulating industries and have an impact on the overall economy.
- Company performance and Public Relations – Volatility does not have to be market wide and can relate to individual companies also. The public image of a company can affect its stock performance by increases or decreases due to PR based successes or failures. Data breaches, product recalls and bad executive behaviour can all hurt a share price as investors sell off their shares. In contrast positive reports such as strong earnings or a new product performing well can give confidence to investors about the business. The larger the company the more likely its performance will affect the broader market.
Volatility can create opportunities
When market prices drop sharply it creates an opportunity to buy shares at a lower price if sitting on cash. If an investor has shares that experience a drop in price due to volatility in the market but believes the market will perform well in the long run, they have an opportunity to buy additional shares in the company but at a lower price and therefore lowering their average cost-per-share which will help to improve their portfolio’s performance when markets eventually rebound.
The same can be said for share prices rising quickly when investors can take advantage by selling out and use the proceeds to invest in other opportunities in the market.
Volatility is part of a long-term investment
As mentioned, there are numerous factors that can cause markets to become volatile and while they might be unsettling, they are all part of a long-term investment journey. By being prepared at the outset for episodes in volatility in an investment journey, investors are less likely to be surprised when it happens and will more likely react positively. Volatility is an integral part of investing and when investors are prepared, they can remain focused on their long-term investment goal. By understanding volatility we can control how we react and our behaviours during market swings and take advantage of potential opportunities that may present themselves. We will delve into our behaviours and investing in the next article so watch this space.
All information and views contained within this article is for informational purposes only and the views expressed do not constitute financial advice. U Consulting makes no representations as to the accuracy, completeness or suitability of any information and will not be liable for any errors, omissions or any losses arising from its use. Please consult a professional financial advisor before making any financial decision.
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Author – Brian Flanagan
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