Market volatility is one of the primary measures of risk in an investment. High volatility is a risk because large fluctuations increase the risk of a loss in value when you may need to sell to get your money back. Volatility can be measured for anything that moves over time: a stock price, index, a mutual fund.
When comparing historical investments, it is, therefore, interesting to compare their performance and their volatility. We are looking for the best-performing investment with the lowest risk. The Y Comparator presents the historical returns of Yomoni management profiles and competing diversified investment funds according to two axes:
- Annualized performance.
- Historical volatility.
Why does market volatility exist?
First, the only assets with zero volatility are those that move in a straight line. They are very rare! Any asset subject to supply and demand will necessarily be volatile. Three factors can explain the volatility of a market:
- A variation in expected income (e.g., for a stock: the expectation of lower than expected future dividends).
- A variation in the certainty of expected income (e.g., for a bond: the risk of non-repayment increases).
- A variation in interest rates (because interest rates modify, via the discounting of future cash flows, the present value of a share).
- A sometimes tiny variation in one of these factors can cause substantial price variations and increase volatility.
For example, if a company announces it has won a significant new contract when investors were not expecting it, its share price may jump. Similarly, if a company in trouble presented a coherent financing plan, its bonds may recover. These are two examples of upward volatility.
Some companies are inherently more volatile: they are the ones that carry the most uncertainty about their earnings. Cyclical companies (automotive suppliers, chemical industry, construction, etc.), unprofitable companies (airlines), or companies that are growing fast but making a loss (many start-ups) are the most volatile.
For bonds, the longer the maturity (10, 20, 30 years…), the more volatile the bond. Indeed, even if we know the price at which the bond will be repaid, we do not know with certainty if the bond issuer will still exist by then. In addition, one is at the mercy of possible increases in inflation, which will penalize the actual value of the amounts recovered at term.
Due to new information, volatility increases when a share’s fair value is suddenly estimated at B while the price is at A. The greater the distance between A and B, the more the price will vary and the greater the volatility. At the scale of an entire market, the increase in volatility can be explained by more global phenomena, for example:
- A change that could influence the earnings of an entire sector or all companies at once (political conflict, war, new regulations…)
- A publication that makes investors realize that they were wrong in their expectations (if car sales statistics are better than expected, investors have good reason to believe that car manufacturers’ profits will be higher than they estimated, and therefore that the price of car stocks should be higher)
- An unexpected change in interest rates. Interest rates affect the price of all financial products and real estate via discounting mechanisms.
More generally, uncertainty and surprise create volatility, both up and down.
How to reduce portfolio volatility
Stocks and cryptos are generally more volatile than bonds, which are generally more volatile than the money market. Passbook accounts have zero volatility (or very low volatility, as their rates change sometimes but not frequently).
Combining several shares lowers the volatility of the portfolio: this is why a stock index is generally less volatile than an individual stock. This is the main attraction of diversification! This is even more true if the sectors are not correlated (if they do not move in the same direction) and if there is geographic and currency diversification. In this share, ETFs are excellent financial instruments because they can diversify.
At the portfolio level, combining stocks and bonds can also reduce volatility. Here again, using ETFs is essential to diversify at a lower cost.
Beware of past market volatility
When calculating market volatility, we use historical data. However, past performance does not predict future performance! This implies that past volatilities do not predict future volatilities. Market volatility varies over time. A quiet stock, or a quiet market, which does not change much, can suddenly become very volatile. This is known as a volatility regime shift, a phenomenon that surprises many investors.
What is implied volatility?
Finally, there is implied volatility. This is a problematic concept because it is not measurable in the market. It reflects the idea that prices are not yet volatile but will be soon. To simplify, it is a bit like if the TGV were to pass through a provincial town one hour from Paris, but we don’t yet know which one. Real estate prices are waiting.
They have risen a little because some buyers have already positioned themselves. Still, we know that as soon as the announcement is official, the selected city will take 20%, and the losers will lose everything they have gained. The price then behaves like a rubber band about to snap: there is tension built up, and as soon as the news comes out, there will be a big move, one way or the other. The volatility is not present, but it is latent.
We speak of implied volatility because this volatility is not yet measurable in asset prices. Still, it is measurable in the price of options, i.e., the price of protection against price variations. On the stock markets, volatility increases before essential decisions (e.g., central bank rate movements) and decreases. In a way, it reflects expectations of future volatility.
How to react in times of high market volatility?
As an investor, volatility can be scary. It can make you feel like you’re losing your entire fortune sometimes, and it can go to your head at other times, making you think you’re the king of oil. The good news is that you don’t have to react. Volatility is a natural part of the market, and trying to respond to it is an excellent way to make mistakes. Here are 3 tips to better withstand volatile sessions:
- Keep a long-term horizon: Sudden swings are part of the journey, but the long-term is essential. Like on the highway: opening the door to look at the road ahead is scary, but looking at the horizon is relaxing. Take a step back, and keep a cool head.
- Diversify: not all assets rise and fall at the same time. Diversifying is the best way to reduce the volatility experienced across a portfolio.
- Use scheduled payments: They take advantage of volatility because, for the same amount each month, you buy more shares after a decline and less after an increase.