What is This Volatility Risk People are Always Talking About?

Perhaps the most common way to measure investment risk is to use volatility. When markets are talked about as being volatile, it’s usually shorthand for saying that risk is high, or that investors are unusually nervous.

But what exactly is volatility, what does it measure, and why is it seen as the same thing as risk? Is it always the most useful way to think about how risky an investment is?

In this article, we look to answer these questions. And to provide some insight into why, despite being a useful tool, volatility shouldn’t be the only way anyone ever thinks about risk.

In the Covid crash, from 20 February to 23 March 2020, the S&P 500 fell 34%. This was the fastest 30% decline in stock market history, and it was caused by the massive uncertainty of what would happen as governments started to impose lockdowns.

As the market dropped, the volatility index (VIX) spiked upwards. It hit an all-time high of over 82 – way above its average level of around 21.

These are more than just interesting statistics for savvy investors. Understanding why volatility shoots up like this during a crisis is useful for understanding more about how markets work.

What is volatility?

In simple terms, volatility measures how much and how quickly market prices change. The price of a staple food like bread is rarely volatile. What you pay for it today is probably the same as you paid for it last week and is usually not much more than you paid last year.

Share prices, however, are always volatile. The stocks of the biggest companies on the JSE are being traded minute-to-minute, and the price changes with almost every trade.

Over just the last year, for example, Naspers shares were as high as R2,775, before falling to R1,427, then climbing again to over R2,850, and sliding again to R1,711.

If the price of bread moved around that much, you would be alarmed. But for investors on the stock market, this is something that they have to accept.

The “fear index”

The scale and pace of changes in share prices is what the VIX measures. It is an indication of how much, and how quickly share prices of companies in the S&P 500 index move around.

In times of crisis, the VIX goes up sharply, because share prices bounce around even more than usual. At the start of Covid lockdowns, for example, no one knew how big the impact on economies would be, or how long they would last. There was no way of telling how badly company profits would be affected.

In this environment, it’s impossible to know what a share price should be. If you can’t do an informed analysis of what a business will be earning, it’s difficult to take a guess at what it is worth.

This is why the VIX is also called the “fear index”. When markets are nervous about the future, it goes up. But when the world is more settled, and people can be more certain about the path of company profits, share prices don’t move around so rapidly. That’s because there is more consensus about what companies are worth.

Volatility and risk

Volatility is often equated to risk, because when the price of something moves around a lot, you can’t be sure what it will be worth from one day to the next. Bitcoin has been a great example.

In November last year, one bitcoin was trading at $67 500. Last month, it dropped below $16,000.

This kind of volatility creates far too much uncertainty for a lot of people. How do you know what your bitcoin will be worth when you need to sell it?

Money saved in a bank, on the other hand, is highly predictable and not at all volatile. The amount never changes, and you know the amount of interest you will earn.

Different kinds of assets

Generally, when people talk about “risk assets”, they mean those that are more volatile, like shares and listed property. Their prices move around a lot and so they don’t make good short-term investments.

If you know you are going to need your money in six months’ time, you don’t want to buy Naspers shares that might drop by 50%. It’s much better to put that money in a bank where you know it will hold its value.

But when you are a long-term investor, you only need your money in 20 or 30 years. That means that what the stock market does today or next week or even next year doesn’t really matter.

That is why when you are thinking over decades, risk assets are more attractive. You are much more likely to generate high returns above inflation and see your money grow over time.

Even though there will be times like 2020 when share prices become massively volatile and uncertainty is high, those times pass. That is because, over the long-term, the real value of real companies making real profits will always be recognised. This will mean that their share prices will grow, benefitting patient investors.

To discuss your long-term investment strategy, speak to a professional.

Disclaimer – *The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.
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