Investment Glossary – Volatility
When we talk about volatility, we’re really talking about the amount of uncertainty a security’s price has over a fixed period of time, usually by measuring the standard deviation or variance in returns over that time period. Now that you’re sufficiently bored, let’s tell you what that means in simpler terms.
When you go to the bank and deposit $100 in your account, that $100 effectively has zero volatility. Unless the bank pays out interest on the account, which is still hard to come by at some banks, your $100 today is going to be $100 tomorrow. And the day after that. And the day after that. It doesn’t change, and it’s guaranteed to continue to exist as $100 by the federal government in the United States. Now, you may lose purchasing power on this $100 due to inflation, but the fact is that if you put $100 in the bank, it’s going to still be $100 at any point in the future if it isn’t earning interest.
Common stock doesn’t quite work that way. That’s because the value of a stock on a day-to-day basis is determined by how investors value its potential future cash flows. Valuations can change based on information the company releases, new economic data, investor sentiment, and a whole host of other factors that go into making the stock market generally a pretty bumpy place to be over short periods of time. So when we talk about volatility in the context of the stock market, we’re talking about how much potential there is for change, either in the market as a whole or in an individual security.
It’s important to note that volatility is not an innate and fixed characteristic of a company. It can change over time based on some of the factors mentioned in the previous paragraph. Companies can be stable for years, only to see their industry go through upheaval and face more uncertainty than they previously experienced. When you buy a company, you aren’t guaranteed a certain level of volatility. But you can look at certain characteristics as a way to form some predictions about it. Does the business have a strong track record? What kinds of competition are they facing? How quickly can they adapt to changing circumstances? Is there regulation that protects their business in some way? Do they have unique intellectual property?
Answering these questions helps to give you some insight as to whether you can reduce the risk of certain events moving a stock’s price. It doesn’t mean that you are going to see a stock with no volatility, but you can potentially reduce the bumpiness of markets in some situations, though the answers to these questions may increase volatility in others. Look at the example of regulated utilities. In many cases, these companies are regulated to make a profit and pay out strong dividends, often making them more stable than the overall market. But in a situation with rising interest rates, regulated utility stocks may face increased volatility as investors look at safer alternatives than relying on dividends for income.
It’s also important to note that volatility doesn’t just work on the way down. A stock that sees a quick jump in its share price has increased volatility as well, as this indicates that investors were not accurately valuing the company to begin with and likely had to make a substantial revaluation when they gained new information on the company. If we look at this through the lens of human nature, it could also lead to increased volatility in the near future since some investors may doubt the new valuation and sell off the stock, or a future piece of news could reverse the previously positive information’s impact and send the stock back to where it came from.
The key point in all of this is that volatility is present in all equity holdings. As you go through your analysis of your own goals and what you should be investing in, you need to make sure you’re taking into account the potential sources of volatility on what you own and whether you are comfortable assuming those risks, or whether there are ways that you can reduce that risk and continue to own the position. Different stocks may have vastly different levels of volatility. This is why you need to do your homework, as boring as it may sound, if you want to be able to understand where volatility comes from and whether it belongs in your portfolio.