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Volatility 101: An Introduction to Market Volatility

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Volatility 101: An Introduction to Market Volatility

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”.

Understanding Volatility

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.

Calculating Volatility

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.

Market Volatility

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.

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Infographics

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.

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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:

Periodic table legend

Here are the seven objectives that the top letters on each box refer to:

Periodic table strategies

And finally, here are the colors that each block on the periodic table correspond to:

Periodic table color coding

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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Investor Education

Here’s How to Become a 401(k) Millionaire

Millionaires are more common than you may think – here are the steps you need to take with your retirement investments to become a 401(k) millionaire.

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Here’s How to Become a 401(k) Millionaire

There’s nothing more definitive in the journey to financial freedom than hitting the $1 million mark in retirement savings.

A nest egg like that is a near-guarantee that you could surmount any curveball the world throws at you, whether it is an unexpected family emergency or anything else.

While $1 million certainly sounds like a lofty milestone to many, it’s actually quite a common achievement:

  • Millionaire households in the U.S.: 11.3 million (8.95%)
  • Total households in the U.S.: 126.2 million

And contrary to popular belief, to become a 401(k) millionaire, you don’t need to strike it rich with a lucky stock pick, or use a crystal ball to forecast the future of the market.

Your best bet is to simply focus only on the factors you can control.

What You Can Control

Today’s infographic is from Tony Robbins, and it covers key points from his #1 Best Selling book Unshakeable: Your Financial Freedom Playbook, which is now available on paperback.

It shows that the biggest winners in the financial game know that they can’t predict the future, and instead titans like Warren Buffett or Jack Bogle focus intently on the factors they can control, knowing that with the right approach they’ll thrive in almost any market.

What are these crucial factors?

FactorDescription
TimeThe force of compound interest is more powerful over longer periods of time.
DisciplineStaying calm and focused on the long term during periods of turmoil is key.
DiversificationProper asset allocation and frequent re-balancing can position you to weather any storm.
ExpensesExpenses and taxes are silent killers, and must be minimized strategically.

By diligently working to take control of these four factors, your odds of attaining financial freedom are extremely high. Here is each factor in more depth.

1. Time

The power of compound interest is extraordinary, making time your best friend when it comes to building a battle chest of retirement savings.

The current maximum contribution limit for 401(k)s is $18,500 per year, not including what is matched by your employer. If you maxed out on contributions and started investing early, you can hit $1 million before retirement even in sub-optimal market conditions:

Starting ageRequired returns for $1 million at age 65
302.20%
353.45%
405.40%
458.55%
5014.50%

Time can make up for a lack of investing acumen. Wait until later, and things get very difficult – by age 50, you need market beating returns!

2. Discipline

If you’re taking advantage of the power of compound interest over a long period of time, whether that is 20, 30, or 40 years, it is inevitable that there will be bumps in the road:

  • Stock market corrections happen once a year, on average
  • Bear markets happen once in every 3-5 years, on average
  • Bear markets vary in length, but on average last one year

Through decades of investing, the fact is you are going to see bear markets – it is how you handle them that counts.

Even when it’s the most tempting to sell, remember these facts:

  • Bear markets become bull markets
  • The first 12 months of a new bull market can see crucial market gains
  • Nobody can successfully time the market – not even the experts

In other words, having the discipline to hold through the turbulence can be the difference maker – and a key factor you can control in your journey to becoming a 401(k) millionaire.

3. Diversification

Another factor you control is portfolio diversification, and here are four ways diversification can minimize risk:

Diversification TechniqueExamples
AssetsStocks, bonds, and alternative assets like real estate or gold.
SectorsConsumer goods, tech, energy, financials, etc.
MarketsDomestic, international, emerging markets
TimeAdd to investments regularly, because there is never a “right” time to buy

A properly designed portfolio can weather any storm, and re-balancing it on a regular basis will force you to sell assets at market highs, while buying at low points.

4. Expenses

The fees on your 401(k) statement might not seem like much, but even 1% or 2% can make a big difference over the long term.

For example: the value of $1 compounding for 50 years at 5% will be worth $11.50, but if it averages 7% it will be worth $29.50. That’s almost three times more!

Expenses, both seen and hidden, can be a silent killer any portfolio, so keeping them to a necessary minimum can help you get to the promised land.

A Final Word

If becoming a 401(k) millionaire was easy, everyone could do it.

But to be successful, you need to take control over factors like time, diversification, discipline, and costs – ideally with a qualified and experienced financial advisor and partner. Then, you need to stick to the plan and let the market do its work.

Investing is a game of inches. If your returns improve by, say, 2 or 3 percentage points a year, the cumulative impact over decades is astounding, thanks to the power of compounding.

– Tony Robbins

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