What is volatility?

Some people dismiss the share market as entirely 'too volatile' and might be scared away from ever investing in the first place. In contrast, risk-seekers might find a thrill or opportunity in the volatility of share prices. 

Volatility is present in all financial markets to at least some degree, so it shouldn't put you off investing. 

In fact, it's the reason you can make a profit out of trading financial assets (like shares) in the first place. If prices didn't vary to some degree, there'd be no chance of you making a capital gain from 'buying low and selling high'. But, at the same time, the uncertainty caused by too much volatility can make even the most seasoned investors feel queasy.

So, how much volatility is too much volatility? How should you view market volatility in the context of a successful, long-term investing strategy? And, most importantly, how can you use market volatility to your advantage without it keeping you up at night?

What do we mean by volatility?

In a financial setting, volatility simply refers to the fluctuation of asset prices over time. All assets are volatile to some degree, with the prices they command moving around regularly in response to economic and other factors. We see this in all types of financial markets, like those for property, bonds, cryptocurrencies, and commodities (like gold).

However, volatility is perhaps most often discussed in connection to share prices and the stock market. 

Why? Well, the unique liquid nature of the share market – combined with its mainstream use — means that the general public is often concerned by dramatic changes in stock prices. Big moves can reflect changes in the health of the broader economy and can reveal a lot about shifts in consumer behaviour.

Not only that, but most people have the majority of their retirement savings invested in shares, either through personal investments or superannuation. This means people have a lot of skin in the game, with market fluctuations – particularly large falls – significantly (and negatively) impacting their wealth.

It's really this last point about the wealth impacts from volatility that is most important one to understand. As we shall explain later, volatility is mostly used to measure the riskiness of a particular financial asset or phase in the market cycle. 

The more volatile asset prices are, the riskier that asset is deemed to be. This is because if you were forced to sell the asset in a hurry (say you suddenly needed some extra cash to cover a large, unexpected expense), its high volatility means there is a greater chance its price will be below where you bought it at (just because it bounces around a lot more).

Its price is more unpredictable, which inherently makes it riskier to own.

The maths

Mathematically, volatility is captured by a share's standard deviation of returns, which is a measure of dispersion around its mean (or average) return.

Don't worry, we won't bore you with formulas (and programs like Excel can calculate standard deviation for you without you needing to know the precise mechanics). But, suffice to say: a company with a share price that changes a lot each day – particularly where the magnitude of those changes appears to be random – would most likely have a high standard deviation.

Its shares would be considered to be far more volatile than those of a company with a stable share price or one that increases (or decreases) at a steady rate over time.

Here's an example

This is probably best demonstrated with a simple example. 

Let's say you are looking at investing in four different shares (A, B, C, and D), but you want to get a sense of their relative volatility first. To do this, you compare the estimated standard deviations of their share price performances over the past five-day trading week. 

It's best to look at the percentage return these shares delivered each day rather than their actual share prices – this means you can compare their performances (and volatility) regardless of their size. 

What's the best way to interpret this information? 

Firstly, Share A has the highest volatility, despite its price overall remaining flat by the end of the week (reflected in its total return of 0%). Share B also ended the week flat, but it had a lower volatility, which you can see reflected in much more stable daily returns than Share A.

Meanwhile, share C ended the week much higher than where it started (a total return of +150%), but it was basically as volatile as Share B. Share D declined -17% throughout the week, but its volatility was the lowest amongst all the shares because its daily returns were very stable.

Their relative volatility can tell you a lot about the shares themselves. Share A is likely a small-cap share because its price is so volatile, and it looks like the riskiest investment. Share B might be more of a mid-cap company, as its price is still somewhat volatile but is much more stable relative to Share A.

And share C looks like a mid-cap growth stock – overall, its price has risen significantly through the week, but its volatility is still roughly equivalent to Share B. 

Finally, Share D is likely to be a more mature company than the others. Its share price declined a little over the week but did so very gradually.

This information can help you decide which share best suits your investment objectives and risk appetite. If you are very risk-averse, you might choose Share D, as it seems to maintain its value and is stable day-to-day. If you are more of a risk-seeker going after growth shares, you might instead choose Share C, as it has delivered a strong overall return – although its volatility is much higher than Share D.

Finally, it should be noted that this is a very simplified volatility example. Typically, you would calculate volatility using returns gathered over a much longer timeframe than just five trading days. And you'd probably also look at daily volatility on an annualised basis. 

What causes volatility?

Many factors can contribute to market volatility, often simultaneously and at varying market levels.

Macroeconomic events can send shockwaves across financial markets. Macro events include wars, trade disputes, geopolitical tensions, global pandemics, and other major disasters.

In addition to macroeconomic events, industry-specific headwinds affect specific market sectors in isolation. For example, COVID-19 lockdowns negatively impacted the travel and tourism sector while simultaneously providing a massive tailwind for the e-commerce industry.

Company-specific news can also create volatility in a company's share price. Investors use company announcements and financial reports to decide whether or not to invest in these companies, so any unexpected news can cause significant movements in a company's stock price.

For example, a surprisingly positive earnings result may cause a company's share price to rise dramatically. On the other hand, reports of changes in company leadership may concern investors and cause them to sell their shares, driving the share price down.

As you can imagine, all manner of different company announcements can affect share prices differently.

What is a 'high' or 'low volatility' share?

When a share is described as high volatility or low volatility, its price movement is typically compared with movements in the broader stock market, often represented by an index such as the S&P/ASX 200 Index (ASX: XJO) or S&P/ASX All Ordinaries Index (ASX: XAO).

Generally, stocks that fall into the growth shares category tend to display higher levels of volatility than value shares or ASX blue chips. This typically involves outperformance against an index during bull markets and underperformance during bear markets. 

In contrast, companies that tend to have resilient and predictable cash flows, like utilities or infrastructure providers, tend to be low-volatility shares. These might underperform during bull markets but provide higher levels of capital protection during bear markets.

Which is the better investment?

Deciding between low- and high-volatility shares really depends on your personal risk appetite, investment objectives, and the market's overall performance. 

Low-volatility shares are best to own if you are risk-averse, concerned with maintaining the value of your portfolio, or worried that the market might be entering a bear phase. Because their prices tend to be more stable, they can provide peace of mind during a financial crisis or period of market upheaval.

High volatility stocks, on the other hand, increase your risks of suffering losses but can also deliver more magnified gains. These are usually small-cap growth stocks and will best suit investors with higher risk tolerance and a desire for outsized returns. There are also likely to be good shares to own in a bull market when share prices are rising.

You can also combine low and high-volatility shares in one diversified portfolio. Maybe you will choose a number of low-volatility defensive shares and then make targeted high-conviction bets on some more volatile growth shares. This can help you keep your overall portfolio volatility relatively low, but you still get some potential upside from investing in one or two growth stocks.

Why is volatility a risk?

Volatility is such an essential metric in the world of finance because it is often considered to be a proxy for risk. The more volatile an asset's price, the riskier we consider that asset to be.

Consider a junior company that has just been listed on the stock exchange. Because little is known about it, and there is no historical financial performance for investors to draw insights, their share prices can react strongly to company updates and other news.

This makes their share price very volatile, which is why investing in them is considered so high risk. One piece of bad news, and your entire investment might go down the drain!

One piece of good news, on the other hand, is that its share price could skyrocket.

This is what's known in investing as the risk-return tradeoff. Unfortunately, it usually goes that the greater the potential payoff, the more likely you are to lose everything chasing it.

Thinking about how you would react to volatility is a good way to evaluate your risk tolerance. If the idea of the value of your investments fluctuating wildly from day to day makes you break out in a cold sweat, then you're probably pretty risk-averse.

But if you can keep a cool head when confronted with short-term losses while focusing on the potential long-term returns on offer, you can probably stomach investing in higher-risk shares.

Your risk tolerance will entirely depend on your personal circumstances, financial situation, and investing goals.

Volatility ratio

We can measure volatility in various ways, either for individual shares or across an entire market. 

How volatile a share is compared with a broader benchmark index is often measured with a metric known as the stock's beta (β). If a company's share price rises and falls entirely in line with its benchmark, it will have a beta of one. 

A beta of less than one indicates that a particular share has a history of being less volatile than its index benchmark. This might mean that for every 1% rise in the benchmark index, the given share's price might only rise 0.8%. But it also implies that for every 1% fall in the index, the given share's price would only fall 0.8%.

Likewise, a beta greater than one implies greater historical volatility than the index. High-growth shares, for example, usually have a beta much greater than one because they typically outperform in a rising market but underperform when prices fall.

Share market volatility

So far, we have talked a lot about individual shares, but what about the stock market as a whole?

The stock market itself can experience periods of heightened volatility. These usually coincide with times of economic, social, or political upheaval, when even the near-term future becomes increasingly difficult to predict.

The last few years have been very volatile for financial markets, including the ASX share market. Investors have had to deal with rising interest rates, high inflation, the lingering effects of the COVID-19 pandemic, the war in Ukraine, and massive supply chain disruptions, to name but a few.

A history of volatility

We don't have to go too far back in time to find examples of extreme volatility. In the past 25 years, financial markets have suffered through the dot-com bubble of 1999, the 2008 global financial crisis, and most recently, the 2020 market crash driven by the COVID-19 pandemic. 

And wedged between these significant market events have been shorter periods of volatility, including corrections and flash crashes.

This tells us that periods of heightened volatility are pretty standard and may even become more frequent. So, although these periods may cause us stress and anxiety, we should understand them as a natural part of the market cycle.

VIX – The volatility index

While a volatility ratio measures the volatility of an individual share against a benchmark, investors typically use a volatility index to gauge the volatility of the benchmark itself against its historical levels. Volatility is unpredictable by nature. 

Take the ASX 200's performance over the past few years as an example.

In 2020, ASX 200 shares crashed by 32.5% between mid-February and mid-March due to the onset of COVID-19, only to rebound 36.7% by the end of the year. We can consider 2020 a high-volatility year for ASX 200 shares.

In contrast, 2021 provided a reasonably smooth run for the ASX 200. The index appreciated 13.02% over the calendar year, with no significant market corrections or crashes. As such, we can describe 2021 as a year of relatively low volatility.

But then 2022 was another fairly volatile year for financial markets, including the ASX 200, due to the onset of the Russia-Ukraine conflict and the global energy crisis. Although the price moves weren't on the same scale as the crash and rebound that occurred in 2020, it was still a bumpy ride for investors.

Investors use an 'index of an index' to measure this market-wide volatility. In Australia, the S&P/ASX 200 VIX Index (ASX: XVI) is considered the gold standard in measuring market volatility. 

A high VIX indicates the market is expecting significant shifts in the value of ASX shares, up or down. In contrast, a low VIX indicates investors are expecting things to more or less carry on as they are.

To see how this works, take a look at the ASX 200 VIX over the past five years below:

ASX 200 VIX and ASX 200 index over five years. Source: Google Finance.

Does volatility matter?

Theoretically, an individual share's volatility doesn't make it a good or bad investment in and of itself. A company's ability to bring in and grow revenue and earnings dictates its potential success or failure as an investment asset.

Many investors actually enjoy the volatility the share market can bring. Wild price swings can be mentally painful but offer opportunities to buy shares at cheaper valuations (sometimes referred to as buying the dip). 

The biggest thing to remember regarding volatility is its emotional impact on investors. Many investors simply can't stomach holding a volatile investment over a long period. 

They might celebrate and buy more shares in a company if its price moves sharply upwards, hoping to double up on a winner. But if the share price falls, investors may panic and sell out, cementing a painful loss.

Both of these hypothetical decisions are emotional in nature. You are more likely to make such decisions if you are a nervous investor and hold shares with a history of volatility compared to the broader market.

How can I stay calm during share market volatility?

On the surface, market fluctuations can seem unpredictable, frightening, and often downright confusing. But it's important to tune out the noise and focus on what matters most: growing your wealth over time. 

This means we shouldn't be overly concerned about short-term price movements. It's important to remember that the share market has consistently generated strong average annual returns over time.

An effective way to minimise the volatility of your investment portfolio is to buy shares in many different companies. Building a diversified portfolio of companies operating across multiple different industries can help reduce your overall risk. Because the share prices of these companies will often respond to news and events in different ways, losses in one section of your portfolio can be offset by gains elsewhere.

Ultimately, we all have to handle market volatility to varying degrees if we want to invest in ASX shares. It can be your friend or enemy, so choose wisely and lean towards ASX shares with a volatility profile that suits your particular investing temperament and risk appetite.

• With additional reporting by Rhys Brock