Understanding Stock Market Volatility: Perception vs. Reality

September 15th, 2008

To the beginning investor, very often the most important question is “Are the ups and downs of stock market investing worth the anxiety”? The 1987 stock market crash (a 508 point drop on October 19, 1987) made headlines. The 190 point mini-crash of October 13, 1989, created a strong perception that the market had become more volatile than ever. And from the look of things, stock market swings of 2% or 3% from one day to the next (which translate into a couple hundred points at current levels) are here to stay. Some volatility is normal. Heck you should even pray for volatility because without it, prices wouldn’t move. And if prices don’t move, there’s not much of a chance to make a profit!

Stock Market Volatility

When the stock market goes up one day, and then goes down for the next five, then up again, and then down again, in no discernible pattern, that’s what you call stock market volatility. In layman’s terms, volatility is like car insurance premiums that go up along with the likelihood of risky situations, such as if you have a poor driving record or if you keep the car in a high-theft area.

Volatility is measured by the Chicago Board of Options Exchange (CBOE), primarily through the CBOE Volatility Index (VIX) and, to a lesser extent, the CBOE Nasdaq Volatility Index (VXN) for technology stocks. The VIX tracks the speed of stocks’ price movements in the S&P 100; the VXN tracks it in Nasdaq 100 stocks. Both indices take a weighted average of the estimated volatility of eight stocks on a particular index. Both are calculated every 60 seconds over the CBOE’s trading day, which means it records a great deal of fluctuation.

Over the 3-month period going from November 2007 to February 2008, the stock market had risen or fallen by at least 1% on more or less half the days. But this volatility is more the result of investors’ nervousness than a reflection of a change in companies’ fundamentals.

Peter Fortune, an economics professor at Tufts University, has conducted research on financial market volatility since 1926. He has reported that, as part of his investigation of the sources of volatility, he had rounded up the usual suspects and found that many did not play a significant role. “In particular, we find no support for the view that increased exchange rate variability, increased federal deficit financing, the introduction of stock index futures, or increased corporate financing leverage have contributed to financial market instability. This does not mean that during very brief episodes these factors have not played a part in shaping volatility. But no evidence was found of a systematic relationship between volatility and these factors that would call for major reforms of financial market mechanisms.”

Most first time investors perceive the stock market to be more volatile because of its typical sharp, sudden price swings. That perception is often reinforced by a simple but often overlooked mathematical relationship. The higher the Dow Jones Industrial Average (DJIA)is, the same percentage change in the index today reflects a much greater move in terms of points. For example, with the DJIA at 800, a 2% change reflects a move of only sixteen points (not very newsworthy). But with the Dow at around 11,000, the same percentage change represents 220 points, and the media focuses on the 220 point drop, not on the percentage.

Furthermore, when you consider 5-, 10-, and 20-year time frames, the volatility issue takes on a whole new meaning. In such time frames, the stock market has proven to be very predictable, almost consistently trending upwards over those periods.

Coping With Stock Market Volatility

As a beginner investor (or a more seasoned one), the best way to cope with market volatility is to develop and maintain a well-diversified investment portfolio; an index fund can allow you to implement a very good diversification strategy without spreading yourself too thin. It’s a good approach to combine with dollar cost averaging, a strategy where investments are made systematically at regular intervals and where investors maintain a long-term investment horizon, avoiding overreacting to short-term market developments. This way you diversify not only your investments, but you also diversify over time.

Stock market volatility will always be a part of investing, but a focused strategy will help weather the more stressful periods when the market is more volatile, since you’ll be focusing on the bigger picture. Success in the market does not depend on predicting the future. Volatility is more dependent on mass hysteria—fear and greed—than on underlying economic or financial events. Those are not reliable emotions on which to base long-term investment decisions. Carve out a 20-year plan and stick to it.