Volatile stocks are characterized by wide price swings of relatively high magnitudes in short time periods, often creating huge trading volumes. Volatility is a positive feature for short-term stock traders. Given their trading experience, they can exploit this volatility for their benefit and potentially book trading profits several times during a period of price swings in a particular stock. (See related: Trading Volatile Stocks with Technical Indicators.)
Are volatile stocks equally beneficial to investors who have a buy-and-hold strategy? A research report from Robeco suggests otherwise: that long-term investment in volatile stocks offers a greater degree of risk in exchange for little high-return potential. There are several challenges associated with investing in highly volatile stocks.
Lack of Business Control
Investors should discover underlying reasons for a stock's volatility before making an investment. Pricing volatility may indicate that the company is facing serious challenges to its business model. For instance, is the company heavily dependent on one major client? Take an auto parts manufacturer whose primary client is one particular automaker, when the latter is applying for a bailout, or a railway carriage manufacturer whose orders could fall due to a decline in government railway spending. The company can be losing market share to an aggressive competitor or its financing could be at the mercy of unstable interest rates. Unless the company can diversify into other streams to mitigate risk, these dependencies and the company's perceived lack of control over its destiny makes its long-term prospects cloudy. (See related: How To Research Volatile Stocks.)
Long Holding Periods
Volatility in stock prices indicates risk and uncertainty, which can endure for long periods of time. Trusting your hard-earned money to such stocks is a gamble, as any positive return potential could take years to materialize. Imagine buying a volatile stock at $60, then seeing it swing between $30 and $50 over the next five years without experiencing any positive returns above your buy price. Although investors can use intermittent price declines to average out their overall buy price by using the Dollar-Cost Averaging (DCA) technique, this may not remove long-term price uncertainty.
Large Capital Requirements
Given potentially lengthy holding periods, trading capital requirements can become substantial for volatile stock investments. Imagine building a portfolio whose significant portion is comprised of volatile stocks, most of which may end up being long-term holds.
Margin Requirements For Short Positions
Even mid-to-long term investors may need to take short positions in volatile stocks, if they have a bearish view of how the market will perform anywhere from a few months to over a year. These short positions will need margin money, which locks in trading capital. In the case of volatile stocks, there's a strong possibility that investors may not reach targeted price levels after taking the short position. So investors can wind up committing a large amount of capital to support their positions and then wind up closing the positions at a loss.
Low Realistic Profit Potential
Even in cases where investors reap profits, inflation and opportunity cost of capital erodes the real rate of return over long periods. Buying a volatile stock at $50, holding it for six years and then selling it at $100 may appear to be doubling your money in six years. But if there had been high inflation levels during those years (say at 8.5% annually), then the realistic gains aren't really that great. Given 8.5% annual inflation, a $50 purchase price would be $81.57 six years later. So inflation effectively erodes the real returns. Alternatively, if there was a risk-free treasury bond (or a less risky corporate bond) which provides a 7% annual return, your $50 purchase would have grown to $75.03 in the same period with a much lower risk level. (See related: Volatility's Impact On Market Returns.)
No Guarantee of Corporate Action Benefits
Income from dividends is an unsung hero for long-term stock investments, as those small returns increase overall returns cumulatively. But volatile stocks often don't pay any dividends regularly, and they may not pay any dividends at all. Additionally, the probability of companies experiencing volatile stock price activity undertaking such corporate actions as stock splits, bonus issues, or rights issues is typically very low. This eliminates one key way that investors see share price improvements, which tend to occur after companies take such actions.
Varying Investor Participation
Given a period of strong price fluctuations, investor interest in a particular stock may decline over time, which will make the stock more illiquid. Eventually this can lead to inefficient price discovery due to there being a smaller number of market participants. The limited number of market makers and other participants offering high bid-ask spreads may put long-term investors at a disadvantage.
Price Open To Manipulations
Due to a reduced number of investors, volatile stock prices may be prone to manipulation by short-term traders. Using such computer-supported strategies like algorithmic trading and high-frequency trading, experts in volatile stocks can have an advantage over "common" investors by trading with greater speed and improved accuracy and having faster access to price quotes.
The Bottom Line
Volatility is the friend of short-term trader but can be the enemy of the long-term investor. Long-term buy-and-hold investors need to be aware of the many potential pitfalls of investing in volatile stocks. Certainly, if pricing volatility turns out to be a temporary factor, buying a volatile stock is good opportunity to cherry-pick valuable companies at a low price. That said, before taking the deep dive in volatile stocks, investors need to examine the business model, market dependencies and competitive landscape of any company in which they're considering investing. (Further suggested reading: Tips For Investors In Volatile Markets and Investment Strategies For Volatile Markets.)