The stock market can be a highly volatile place, with wide-ranging annual, quarterly, even daily swings of the Dow Jones Industrial Average. Although this volatility can present significant investment risk, when correctly harnessed, it can also generate solid returns for shrewd investors.

Key Takeaways

  • Stock market volatility is generally associated with investment risk; however, it may also be used to lock in superior returns.
  • Volatility is most traditionally measured using the standard deviation, which indicates how tightly the price of a stock is clustered around the mean or moving average.
  • Larger standard deviations point to higher dispersions of returns as well as greater investment risk.

Volatility Defined

Strictly defined, volatility is a measure of dispersion around the mean or average return of a security. Volatility can be measured using the standard deviation, which signals how tightly the price of a stock is grouped around the mean or moving average (MA). When prices are tightly bunched together, the standard deviation is small. Contrarily, when prices are widely spread apart, the standard deviation is large.

As described by modern portfolio theory (MPT), with securities, bigger standard deviations indicate higher dispersions of returns, coupled with increased investment risk.

Market Performance and Volatility

In a 2011 report, Crestmont Research studied the historical relationship between stock market performance and volatility. For its analysis, Crestmont used the average range for each day to measure the volatility of the Standard & Poor's 500 Index (S&P 500). Their research found that higher volatility corresponds to a higher probability of a declining market, while lower volatility corresponds to a higher probability of a rising market. Investors can use this data on long term stock market volatility to align their portfolios with the associated expected returns.

For example, as shown in the table below, when the average daily range in the S&P 500 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.

Source: Crestmont Research

Factors Affecting Volatility

Regional and national economic factors, such as tax and interest rate policies, can significantly contribute to the directional change of the market, thereby potentially greatly influencing volatility. For example, in many countries, when a central bank sets the short-term interest rates for overnight borrowing by banks, their stock markets often violently react.

Changes in inflation trends, plus industry and sector factors, can also influence the long-term stock market trends and volatility. For example, a major weather event in a key oil-producing area can trigger increased oil prices, which in turn spikes the price of oil-related stocks.

The VIX is intended to be forward-looking, measuring the market's expected volatility over the next 30 days.

Assessing Current Volatility in the Market

The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) detects market volatility and measures investor risk, by calculating the implied volatility (IV) in the prices of a basket of put and call options on the S&P 500 Index. A high VIX reading marks periods of higher stock market volatility, while low readings mark periods of lower volatility. Generally speaking, when the VIX rises, the S&P 500 drops, which typically signals a good time to buy stocks.

The Bottom Line

The higher level of volatility that comes with bear markets can directly impact portfolios, while adding stress to investors, as they watch the value of their portfolios plummet. This often spurs investors to rebalance their portfolio weighting between stocks and bonds, by buying more stocks, as prices fall. In this way, market volatility offers a silver lining to investors, who capitalize on the situation. (For related reading, see "How to Bet on Volatility When the VXX Expires")