Volatility 101: An Introduction to Market Volatility
Almost all assets see fluctuations in value over time.
But while price swings are a common phenomenon in most asset classes that exist, they are the most famous in the stock market.
These upward and downward movements in price are known as volatility, which is defined as “a measure of the frequency and severity of price movement in a given market”.
Today’s infographic comes to us from Fisher Investments, and it serves as an introduction to the concept of volatility, along with offering a perspective on volatility’s impact on investments.
Why are certain times more volatile than others?
In the short term, volatility is driven by changes in demand, which is largely related to changes in earnings expectations. These expectations can be affected by:
- Earnings reports
- New economic data
- Company leadership changes
- New innovations
- Herd mentality
- Political changes
- Interest rate changes
- Market sentiment swings
- Other events (economic, political, etc.)
Often the media and investors assign certain narratives to price changes, but the reality is that the stock market is very complex, and has many underlying factors that drive movements.
What ultimately matters for volatility is demand: if stocks move up or down on a given day, we can say definitively that demand for stock was more (or less) than stock supply.
Technically speaking, volatility is a statistical measure of the dispersion of returns for a given security or market index over a specific timeframe.
In other words, two stocks may have the same average rate of return over a year, but one may have daily moves of 1%, while the other may jump around by 5% each day. The latter stock has a higher standard deviation of returns, and thus has higher volatility.
Here’s what you need to know about standard deviation, which is a common measure of volatility:
- Roughly 68% of returns fall within +/-1 standard deviation
- To calculate standard deviation, differences must be squared. This means negative and positive differences are combined
- Standard deviation tells you how likely a particular value is, based on past data
- Standard deviation doesn’t, however, show you the direction of movement
This all gets more interesting as we look at the market as a whole, in which thousands of stocks (each with their own individual volatility) are moving up and down simultaneously.
Now that you can see how volatility plays out with individual stocks, it makes sense that market volatility is the overall volatility from the vast collection of stocks that make up the market.
In the United States, the most watched stock market index is the S&P 500 – a collection of 500 of the largest companies listed in the country. One measure of the volatility of the S&P 500 is the CBOE Volatility Index, or as it is known by its ticker symbol, the VIX.
Volatility and market sentiment in the overall market are important, because humans tend to experience the pain of loss more acutely than the upside of gains – and this can impact short-term decision making in the markets.
Negative price swings in the wider market can be distressful and unnerving for investors, and high volatility does present some challenges:
- Uncertainty in the markets can lead to fear, which can lead investors to make decisions they may otherwise not make
- If certain cashflows are needed at a later date, higher volatility means a greater chance of a shortfall
- Higher volatility also means a wider distribution of possible final portfolio values
That said, volatility also represents a chance of better returns than expected – and for long-term investors that are patient, volatility can help drive outcomes.
How Equities Can Reduce Longevity Risk
With life expectancies increasing, will you outlive your savings? Learn how allocating more of your portfolio to equities may reduce longevity risk.
Will You Outlive Your Savings?
The desire to live longer — and outrun death — is ingrained in the human spirit. The first emperor of China, Qin Shi Huang, may have even drank mercury in his quest for immortality.
Over time, advice for living longer has become more practical: eat well, get regular exercise, seek medical advice. However, as life expectancies increase, many individuals will struggle to save enough for their lengthy retirement years.
Today’s infographic comes from New York Life Investments, and it uncovers how holding a stronger equity weighting in your portfolio may help you save enough funds for your lifespan.
Longer Life Expectancies
Around the world, more people are living longer.
|Year||Life Expectancy at Birth, World|
Despite this, many people underestimate how long they’ll live. Why?
- They compare to older relatives.
Approximately 25% of variation in lifespan is a product of ancestry, but it’s not the only factor that matters. Gender, lifestyle, exercise, diet, and even socioeconomic status also have a large impact. Even more importantly, breakthroughs in healthcare and technology have contributed to longer life expectancies over the last century.
- They refer to life expectancy at birth.
This is the most commonly quoted statistic. However, life expectancies rise as individuals age. This is because they have survived many potential causes of untimely death — including higher mortality risks often associated with childhood.
Amid the longer lifespans and inaccurate predictions, a problem is brewing.
Currently, 35% of U.S. households do not participate in any retirement savings plan. Among those who do, the median household only has $1,100 in its retirement account.
Enter longevity risk: many investors are facing the possibility that they will outlive their retirement savings.
So, what’s the solution? One strategy lies in the composition of an investor’s portfolio.
The Case for a Stronger Equity Weighting
One of the most important decisions an investor will make is their asset allocation.
As a guide, many individuals have referred to the “100-age” rule. For example, a 40-year-old would hold 60% in stocks while an 80-year-old would hold 20% in stocks.
As life expectancies rise and time horizons lengthen, a more aggressive portfolio has become increasingly important. Today, professionals suggest a rule closer to 110-age or 120-age.
There are many reasons why investors should consider holding a strong equity weighting.
- Equities Have Strong Long-Term Performance
Equities deliver much higher returns than other asset classes over time. Not only do they outpace inflation by a wide margin, many also pay dividends that boost performance when reinvested.
- Small Yearly Withdrawals Limit Risk
Upon retirement, an investor usually withdraws only a small percentage of their portfolio each year. This limits the downside risk of equities, even in bear markets.
- Earning Potential Can Balance Portfolio Risk
Some healthy seniors are choosing to work in retirement to stay active. This means they have more earning potential, and are better equipped to recoup any losses their portfolio may experience.
- Time Horizons Extend Beyond Lifespan
Many individuals, particularly affluent investors, want to pass on their wealth to their loved ones upon their death. Given the longer time horizon, the portfolio is better equipped to ride out risk and maximize returns through equities.
Higher Risk, Higher Potential Reward
Holding equities can be an exercise in psychological discipline. An investor must be able to ride out the ups and downs in the stock market.
If they can, there’s a good chance they will be rewarded. By allocating more of their portfolio to equities, investors greatly increase the odds of retiring whenever they want — with funds that will last their entire lifetime.
The Periodic Table of Investments
The investment universe is vast – but it’s also made up of many smaller components. See it all depicted in this nifty periodic table of investments.
Periodic Table of Investments
The investment universe is vast, but it’s also made up of many smaller moving pieces.
For serious investors, the foundation of the discipline is to understand the properties of these individual components, and to have them work in harmony to achieve a specific portfolio goal.
To do this successfully, one must understand the breadth of asset classes, tactics, and categories of investments that exist – and to know how they relate to one another.
The Chemicals Between Us
Today’s infographic comes from Phil Huber, the Chief Investment Officer for Huber Financial Advisors, who has cleverly depicted this relationship graphically in his blog.
Similar to how the physical universe is made up of chemical elements, he sees the possibilities around portfolio management as drawing from a broad pool of investing “elements”. Combine these different elements together, and you get compounds, structures, and eventually entire funds.
The periodic table of investments created by his team denotes each type of investment, the primary and secondary strategy related to it, and a color classification:
Here are the seven objectives that the top letters on each box refer to:
And finally, here are the colors that each block on the periodic table correspond to:
As you can see, considerable thought has been put into the categories and classifications. However, as Phil notes, this is simply the opinion of one person and it is not intended to be a universally accurate depiction of all portfolio management wisdom that exists:
I fully expect that there are a handful of omissions, or perhaps a few areas where one might flat-out disagree with how I’ve laid things out. This was not meant to be 100% exhaustive, nor was it meant to be indicative of what one of our portfolios looks like.
Phil Huber, Chief Investment Officer
For more of the lessons that can be derived from this clever periodic table of investments, we suggest checking out the original post on Huber’s blog.
Is there anything that he missed, or that you think could be classified better?
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