What is the Concept of Volatility?

By: First Union | Date:

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What is the Concept of Volatility?

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Over time, the price of a security can fluctuate up or down. The degree to which this fluctuation occurs is called volatility. Those investors who've studied the stock market and understand the nature of volatility can profit from it, though it does take fairly comprehensive knowledge of securities and how they work. In this article, we look at the concept of volatility and consequently how it works.

Understanding Volatility

When it comes to investing, volatility is the term used to describe the up and down movements of stock, mutual fund, or bond prices. It can however also refer to the overall fluctuation within the stock market as a whole. With individual securities, the greater the volatility stock has, the more that stock can potentially gain in value or on the flip side, decrease in value. This is why investors need to pay attention to volatility.

With every investment particularly in stocks, there is most definitely risk involved. The volatility of stock prices stands as one of the major risks investors face. Any security is bound to experience upticks and downslides in terms of value. This occurs for many reasons. It could be that a new product launch proves highly successful and thus the value of the stock goes up. A company could be suffering from mismanagement causing stock prices to drop drastically at times. Investors do not have control over the factors that tend to dictate price shifts, but they do need to be able to understand the volatility associated with certain types of securities to make the smartest investment choices possible for their portfolio. For example, stocks do tend to have a higher return than most bonds, but they are also more volatile. Bonds produce less of a return but have relatively low volatility associated.

Often, investors will refer to Volatility Charts for better comprehending the volatility connected to a specific investment. Volatility charts offer insights in terms of what "normal" volatility may be. Looking at a historical record of how a stock has performed and consequently what its price has done, can allow for making more informed decisions regarding whether or not to purchase a security and how much of that security to purchase. Such charts also pinpoint patterns in stock value increases/decreases which is good to know as far as understanding when to buy and when to sell.

While volatility certainly does factor into stock value, it almost always returns to normal levels after reaching an extreme value. How long it takes to get back to "middle ground" can be difficult to forecast however—it could potentially be a few days or even a few months. For the most part, volatility will increase as stock prices drop and then decrease as they rise. This is largely in part because falling values equate to greater uncertainty and therefore less market stability. On the flip side, increasing prices mean more certainty and thus less volatility.

The Best Ways to Manage Volatility

If investors are looking to invest amid volatility, there are a few things they need to keep in mind to ensure they are making logical and prudent investments.

Risk versus reward: Going into an investment, an investor needs to be aware of their overall risk tolerance. In other words, if investing in stocks, an investor needs to know that there is a higher risk involved as there can be more volatility connected to stocks. Are you willing to accept this risk, if eventually, the payoff is greater than with mutual funds or bonds for example? Over the short term, an investor could stand to lose a fair amount of money in stocks; however, over the long term, the return could be substantially greater than with other types of securities.

Without question, if you do invest in stock versus less volatile security, you are going to want to make sure that over time the reward could potentially supersede the risk. You do this by looking at the history of the stock's performance. You can also compare it to similar stocks. That said, there is no guarantee that past performance for instance will dictate future performance. Some strategies when investing in the stock market as far as managing volatility.

Have a diversified portfolio: As far as the types of securities you invest in, it is always good practice to keep your portfolio diversified. The various assets you invest in should offer a range of volatility levels; this way if a certain stock does prove more volatile if you have bonds and mutual funds as well, the portfolio value will decrease less even if stock prices drop significantly.

  • Keep with your plan: If you are consistently just selling your shares as prices fall, you are on a path that could be problem-plagued as far as potentially making money. You need to determine your investment strategy and stick to it versus panic buying and selling as the market fluctuates.
  • Have a long term strategy: Volatility is a factor but more so over the short term. Depending on your investment plan, portfolio, and the amount you're looking to invest, it might be better to have a long term strategy in mind. Even if a stock in which you invest dips significantly, odds are it will rebound.
  • Profit from volatility: Some investors will take the risk and buy those stocks that are particularly volatile—these are ones that generally no one else wants. As a result, over time you could stand to make more because of that volatility.

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