What is Volatility?

Volatility is a term you will hear frequently during discussions about investing and the share market. Here’s a deep dive into exactly what it means.

Yellow road sign with 'Volatility ahead' written on it
Image source: Getty Images

Some people dismiss the share market entirely as “too volatile”. Others find thrill or opportunity in the volatility of shares. 

So, how should we view volatility in the context of successful, long-term investing?

What do we mean by volatility?

In a financial setting, volatility simply refers to the fluctuation of asset prices – or ASX shares in this context. All assets are technically volatile, as the prices they command can move around, sometimes wildly. We see this not just in shares, but in the property market, the bond market, cryptocurrency markets and in commodity prices such as gold.

But volatility is perhaps most discussed in connection to shares. 

Why? Well, the unique liquid nature of the share market combined with its mainstream use means that many investors are highly concerned by the dramatic revaluations of companies in the share market that periodically occur.

At its core, volatility measures the frequency that an asset’s price deviates from its average.

What is a ‘high volatility’ or ‘low volatility’ share?

When a share is described as ‘high volatility or ‘low volatility’, its price movement is typically being compared to the broader market, represented by an index such as the S&P/ASX 200 Index (ASX: XJO).

On a basic level, shares 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 the 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.

Volatility ratio

Volatility can be measured in various ways, either for individual shares or across an entire market. 

How volatile a share is compared with the broader benchmark index is often measured with a metric known as the beta (β). If a company’s volatility rises and falls completely in line with its benchmark, it will have a beta of 1. 

A beta less than 1 indicates the particular share has a history of being ‘less volatile’ than its index benchmark. Likewise, a beta greater than 1 implies greater historical volatility than the index.

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, by nature, is unpredictable. 

Take the ASX 200’s performance in 2020 and 2021 as an example.

In 2020, ASX 200 shares crashed by 32.5% between mid-February and mid-March, only to rebound 36.7% by the end of the year. As such, we can consider 2020 to be a high volatility year for ASX 200 shares.

In contrast, 2021 has been a fairly smooth run for the ASX 200 thus far. The ASX 200 has appreciated by  10.8% over the year to early December, with no major market corrections or crashes. As such, we can describe 2021 so far as a year of relative low volatility.

Investors use an ‘index of an index’ to measure this market-wide volatility. In Australia, the S&P/ASX 200 VIX Index (INDEXASX: 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, whether that be up or down. In contrast, a low VIX indicates investors are expecting things to more or less carry on as they are.

For an idea of how this works, take a look at the ASX 200 VIX over the past 5 years below:

asx 200 volatility XVI

A-VIX chart and price data over 5 years, data from 10.9.2021. 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. It’s a company’s ability to bring in and grow revenues and earnings that really dictates its potential success or failure as an investment asset.

Many investors actually enjoy the volatility that the share market can bring. Wild price swings can be mentally painful, but can also offer regular opportunities to buy shares at a cheap valuation. 

The biggest thing to keep in mind regarding volatility is its emotional impact on investors. Many investors simply can’t stomach holding a volatile investment over a long period of time. 

They might celebrate and buy more shares in a company if it’s price moves sharply upwards, hoping to double-up on a winner. But if the share price falls, an investor 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.

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

Guide last updated 17 December 2021. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.