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.

See: Option Volatility

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 a lower-than-expected return, the riskier the investment. (For more insight, read Modern Portfolio Theory: Why It's Still Hip and Find The Highest Returns With The Sharpe Ratio.)

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 the mean. The greater the dispersion of returns around the mean, the larger the drop in the compound return.

In a 2011 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 to 1%) the odds are high (about 70% monthly and 91% annually) that investors will enjoy gains of 1.5% monthly and 14.5% annually.

When the average daily range moves up to the fourth quartile (1.9 to 5%), there is a probability of a -0.8% loss for the month and a -5.1% 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 – Dec. 31, 2011)

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% 2.9% -1.9% 1.5%
2nd 1.0-1.4% 61% 39% 3.0% -2.1% 1.0%
3rd 1.4-1.8% 59% 41% 3.2% -3.2% 0.6%
4th 1.8-2.6% 41% 59% 5.2% -5.0% -0.8%
Annual Data (1962 – 2011): 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 0-1.1% 91% 8% 15.8% -1.5% 14.5%
2nd 1.0-1.5% 75% 25% 15.7% -6.0% 10.3%
3rd 1.5-1.8% 83% 17% 14.2% -11.6% 9.9%
4th 1.8-2.7% 38% 62% 17.7% -19.4% -5.1%
Source: Crestmont Research

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.

Factors That Affect Volatility
Region and country economic factors, such as tax and interest rate policy, contribute to the directional change of the market and thus volatility. For example, in many countries, the central bank sets the short-term interest rates for overnight borrowing by banks. When they change the overnight rate, it can cause stock markets to react, sometimes violently.

Changes in inflation trends influence the long-term stock market trends and volatility. Expanding price-earning ratios (P/E ratio) tend to correspond to economic periods when inflation is either falling or is low and stable. This is when markets experience low volatility as they trend higher. On the other hand, periods of falling P/E ratios tend to relate to rising or higher inflation periods when prices are more unstable. This tends to cause the stock markets to decline and experience higher volatility. (To learn more, see Can Investors Trust The P/E Ratio?)

Industry and sector factors can also cause increased stock market volatility. For example, in the oil sector, a major weather storm in an important producing area can cause prices of oil to jump up. As a result, the price of oil-related stocks will follow suit. Some benefit from the higher price of oil, others will be hurt. This increased volatility affects overall markets as well as individual stocks.

Assessing Current Volatility in the Market
Using Crestmont's research, investors can use their understanding of the longer term volatility of the stock market to align their portfolios with the expected returns. But, how do we know if the market is experiencing higher volatility?

One way is to use the CBOE Volatility Index (VIX). The VIX measures the implied volatility (IV) in the prices of a basket of put and call options on the S&P 500 Index. The VIX is used as a tool to measure investor risk. A high reading on the VIX marks periods of higher stock market volatility. This high volatility also aligns with stock market bottoms. Low readings on the VIX mark periods of lower volatility. The periods of low volatility may last several years and are not as good for identifying market tops. The VIX is intended to be forward looking, measuring the market's expected volatility over the next 30 days.

As a general trend, when the VIX rises the S&P 500 drops. When the VIX is at a high, the S&P 500 is at a low, which may be a good time to buy. However, if the VIX is high, there is a concern that the market is going to continue to go down. This fear makes it difficult to buy during high stock market volatility. But, investors who used the high on the VIX to time their buys entered the market at or near the low. (To find out how the VIX measures volatility, read Getting a VIX on Market Direction.)

Volatility works well to help identify market bottoms based on high volatility. For long-term investors, it also does a pretty good job of helping to identify that the stock market is at or near a top, when volatility is very low. Keep in mind that this indicator is not intended to time the exact top, but rather that the volatility of the market does not stay substantially below the mean for a long period of time. As the volatility increases, then the market's performance will tend to decrease.

The higher level of volatility that comes with bear markets has a direct impact on portfolios. It also adds to the level of concern and worry on the part of investors as they watch the value of their portfolios move more violently and decrease in value. This causes irrational responses which can increase investors' losses. As an investor's portfolio of stocks declines, it will likely cause them to "rebalance" the weighting between stocks and bonds by buying more stocks as the price falls. Investors can use volatility to help them buy lower than they might have otherwise.

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