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Many investors realize that the stock market is a volatile place to invest their money. The daily, quarterly and annual moves can be dramatic, but it is this volatility that also generates the market returns investors experience. In this article we'll explain how volatility affects investors' returns and how to take advantage of it.
Volatility Defined
Volatility is a measure of dispersion around the mean or average return of a security. One way to measure volatility is by using the standard deviation, which tells you how tightly the price of a stock is grouped around the mean or moving average (MA). When the prices are tightly bunched together, the standard deviation is small. When the price is spread apart, you have a relatively large standard deviation.For securities, the higher the standard deviation, the greater the dispersion of returns and the higher the risk associated with the investment. As described by modern portfolio theory (MPT), volatility creates risk that is associated with the degree of dispersion of returns around the average. In other words, the greater the chance of lower-than-expected return, the riskier the investment. (For more insight, read Modern Portfolio Theory: An Overview and Modern Portfolio Theory Stats Primer.)Another way to measure volatility is to take the average range for each period, from the low price value to the high price value. This range is then expressed as a percentage of the beginning of the period. Larger movements in price creating a higher price range result in higher volatility. Lower price ranges result in lower volatility. (For related reading, see Measure Volatility With Average True Range.)
Market Performance and Volatility
There is a strong relationship between volatility and market performance. Volatility tends to decline as the stock market rises and increase as the stock market falls. When volatility increases, risk increases and returns decrease. Risk is represented by the dispersion of returns around mean. The greater the dispersion of returns around the mean, the larger the drop in the compound return.
In a 2007 report, Crestmont Research examined the historical relationship between stock market performance and the volatility of the market. For this analysis, Crestmont used the average range for each day to measure the volatility of the Standard & Poor's 500 Index (S&P 500) index. Their research tells us that higher volatility corresponds to a higher probability of a declining market. Lower volatility corresponds to a higher probability of a rising market.
For example, as shown in the table below, when the average daily range in the S&P 500 Index is low (the first quartile 0-1%) the odds are high (about 70% monthly and 91% annually) that investors will enjoy gains of 1.3% monthly and 12.9% annually.When the average daily range moves up to the fourth quartile (1.8-2.6%), there is a probability of a -0.4% loss for the month and a -4.1% loss for the year. The effects of volatility and risk are consistent across the spectrum.
Relationship of Volatility and Market Returns
(S&P 500 Index: 1962 – January 31, 2007)
Monthly Data: S&P 500 Index Average Daily Range |
| Quartile |
Volatility Range |
% Chance Up Month |
% Chance Down Month |
If Up Avg Gain |
If Down Avg Loss |
Expected Gain/(Loss) |
| 1st |
0-1.0% |
70% |
30% |
2.7% |
-1.8% |
1.3% |
| 2nd |
1.0-1.4% |
61% |
39% |
3.1% |
-2.2% |
1.0% |
| 3rd |
1.4-1.8% |
59% |
41% |
3.1% |
-3.1% |
0.6% |
| 4th |
1.8-2.6% |
44% |
56% |
5.0% |
-4.6% |
-0.4% |
| Annual Data (1962 – 2006): S&P 500 Index Average Daily Range |
| Quartile |
Volatility Range |
% Chance Up Month |
% Chance Down Month |
If Up Avg Gain |
If Down Avg Loss |
Expected Gain/(Loss) |
| 1st |
0-1.0% |
91% |
9% |
14.3% |
-1.5% |
12.9% |
| 2nd |
1.0-1.4% |
82% |
18% |
19.1% |
-9.0% |
14.0% |
| 3rd |
1.4-1.8% |
82% |
18% |
15.6% |
-11.6% |
10.6% |
| 4th |
1.8-2.6% |
42% |
58% |
13.4% |
-16.6% |
-4.1% |
This research shows that we need to be aware of the volatility in the market if we hope to adjust our portfolios as it changes.
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