How to Understand (and Plan For) Market Volatility
After the nail-biting roller coaster ride that was the stock market’s reaction to COVID-19, you could hardly be blamed for wanting nothing to do with stock market volatility.
The thing is, the stock market has always been volatile (sometimes more so than others, of course). That volatility isn’t always a bad thing. It’s at the heart of investing.
The key is not to avoid stock market volatility, but knowing how to plan for market volatility. Here’s a breakdown of how market volatility works and how you can plan ahead for the ebbs and flows of the market.
What is Market Volatility?
Stock market volatility is the measure of how much the stock market’s value fluctuates up and down. It isn’t just market-wide either. Individual stocks can rise and fall in price in seconds, even if it’s just by a few cents here or there.
Volatility is measured by looking at how far an asset’s price varies from its average price, expressed as a standard deviation.
What Drives Volatility?
Unfortunately, there is no mathematical formula for volatility. There are measures to calculate volatility, but understanding volatility isn’t a solve-for-X problem you might have learned in high school algebra. Remember, the stock market is based on what investors are willing to pay for equities, which means the stock market itself can ebb and flow based on investor confidence (regardless of whether or not that confidence is rational).
On one hand, there are obvious factors which influence a stock’s growth, like the company’s performance in its industry overall. However, the stock market is also influenced by outside events and how consumers perceive them—as in the case of widespread fear attached to the COVID-19 pandemic.
Is Volatility Good or Bad?
Volatility can be hair-raising, but the reality is that it’s not an inherently negative phenomenon. It’s right at the heart of investing and can be a good thing or a bad thing—it depends entirely on context.
Part of the reason why volatility has a bad reputation is that it only makes the news when it’s bad, like when the news reports omens of an oncoming bear market. But keep in mind that volatility is also the reason why your investments can grow in value over time.
Also, keep in mind that having stocks lose value also comes with silver linings. For investors poised to take advantage of them, dropping stock prices present an excellent opportunity to snatch up equities while they’re still cheap and capitalize when they grow.
Why Put Money in a Volatile Market?
So, why would you put your money in a volatile market?
One way or another, volatility is part of investing. If the market were stable all the time, there wouldn’t be any difference between investing your money and tossing it in a savings account. On one hand, volatility can hurt your portfolio, but it’s also the reason why your portfolio grows over time.
Again, the key is not to avoid market volatility altogether—some volatility is a good thing. The key is to make the most of good volatility and insulate your portfolio against bad volatility.
How to Plan for Market Volatility
While you can’t predict market volatility (after all, who can predict what surprises next year, next week, or even tomorrow might hold?), you can take steps to protect your portfolio against the inevitability of volatility. You can even capitalize on good volatility when it arises.
Here are a few strategies to keep in mind.
Practice Hedging and Black Swan Investing
Black swan investing is an investing philosophy based on the idea of a black swan, an extremely rare, catastrophic event which is nearly impossible to predict, yet has severe long-term consequences for the market. Black swan investing strategies warn that you should plan for the eventuality of a catastrophic event, whatever that event might be.
Rather than betting on the market to succeed or fail one way or another, you buy options on both sides (oh, and since you’re betting on catastrophes, you buy out-of-the-money options). That way, regardless of which way the market crumbles, you never sacrifice your entire portfolio.
Basically, black swan investing is a type of hedging. Say you own shares in a company. You’re reasonably confident in the company, but you’re worried about short-term losses in the industry, so you buy a put option, which gives you the right to sell at a specific price. That way, if the company fails, you minimize your losses.
Here’s the thing: the market will always take swings. But if you have bets on both sides, you’ll be safe no matter which way the wind blows.
Be Smart About Using Market Hedges (Diversify, Diversify, Diversify)
With that in mind, always refer back to the three golden words of investing: diversify, diversify, diversify. Especially if you’re using assets as market hedges.
For example, no healthy portfolio will consist entirely of stocks. That runs too much risk of losing everything. Instead, a typical portfolio will carry some insulation with bonds and cash. A smart alternative investor will get further insulation by investing in market hedges that don’t move in tandem with the market, allowing them to act as rescue assets if the need ever arises.
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