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Understanding Stock Market Volatility as a Means to Improving Our Investment Returns

Understanding Stock Market Volatility as a Means to Improving Our Investment Returns

On a daily basis, the financial press is replete with references to “stock market volatility” and its impact on pricing and returns. But what is volatility as it applies to the stock market? Furthermore, how can our understanding of volatility work in our favor when making investment decisions?

Stock market volatility refers to the price behavior of stocks. When the price of a stock moves up or down in small increments over a period of time, it is said to have a “low volatility”. Conversely, when the price of a stock moves up or down in an erratic manner over a period of time, it is said to have a “high volatility”. When these differing price behaviors are characteristic of all or most stocks at the same time, the overall market may be described as having low volatility or high volatility respectively.

Frequent and largely varying price moves (high volatility) result from greater uncertainty—and therefore greater risk. Typically, as we see the volatility increasing, it is seen as the signal for a forthcoming decline in prices. Investors, for example, may interpret rising interest rates or government policy changes as signaling lower values for stocks and tend to liquidate accordingly. High volatility feeds on itself, because as the uncertainty grows more and more, a greater number of investors seek to liquidate their holdings and the price behavior becomes even more erratic.

One way to measure volatility is to use the Chicago Board Options Exchange Volatility Index (VIX). The VIX1 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 has historically aligned with stock market bottoms. The reason it aligns with market bottoms is because as it increases and rises to new heights, investors are liquidating their shares along the way, pushing prices down. Again, from a historical perspective, as the VIX peaks, it has been shown that stock prices have bottomed and been a good “buy signal” to investors.

Conversely, 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. This is because investors are still accumulating stocks during these periods because there have been no alarming risk signals, such as higher interest rates or increasing inflation. The VIX is intended to be forward looking; measuring the market's expected volatility over the next 30 days. However, because it is ever-changing, it continues to provide a 30 day forward view of market price expectations.

Our current market environment calls for a greater awareness of the volatility measure as recent months have clearly pointed to greater uncertainty. In my opinion, the greatest uncertainty at the present time centers on interest rates. Clearly, a historical analysis shows that higher interest rates result in lower stock prices (greater costs of borrowing leading to lower net incomes for any company accessing the credit markets). As the Federal Reserve Board has signaled that it will reduce the amount of intervention it has undertaken to keep interest rates low, it is logical to assume that we will see rates rise. In fact, the rate on the 10-year US Government Bond, a benchmark in the full array of interest rate markets, has moved from 1.6% to 2.9% in just the last eight months. For those familiar with interest rate markets, this has been a stunning rise in such a short period of time. The current question is: Will this rate increase will be permanent and is there more to come, or has this been a temporary aberration which will subside as quickly as it has developed?

¹http://www.investopedia.com/terms/v/vix.asp

The interest rate question is paramount to predicting stock market values. Therefore, an understanding of stock market volatility driven by interest rate movement is critical to the ability to make good investment decisions in the coming months. It is important to remember that whether we choose individual stocks to build our portfolios or rely on various investment vehicles, such as mutual funds or variable annuities which include stocks as a component of the investment; stock market volatility will impact our results. Therefore, a better understanding of stock market volatility can help lead to better timing of our purchases and sales of all equity investments.

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©Patrick J. Catania 2013
The views and opinions expressed herein are solely those of the author and do not necessarily reflect those of Baxter Credit Union, its Board of Directors, or its employees. The author is responsible for the content. Readers should consult with, and seek professional advice from their own attorneys, accountants, and financial advisors with respect to their individual financial needs and circumstances.