Motley Fool Australia

What is Volatility?

Yellow road sign with 'Volatility ahead' written on it

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Volatility is a term you will hear frequently during discussions about investing and the share market. Some people dismiss the share market entirely as ‘too volatile’. Others find thrill or opportunity in the volatility that shares can throw up. 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, highly liquid nature of the share market combined with its mainstream use means that many investors are highly concerned with the dramatic re-valuations 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’, it typically compares the movements of an individual company’s share price to that of 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, some 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 and either for individual shares or of 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 its nature is unpredictable. Take the ASX 200’s performance in 2019 and 2020 (so far) as an example. 2019 saw a very smooth run for ASX 200 shares appreciate around 20% over the year, with no major market corrections or crashes. Historically, it was a year of ‘low volatility’. 

In contrast, 2020 has already seen ASX 200 shares crash by more than 36% between February and March, only to rebound more than 27% off of these lows since. As such, we can consider 2020 to be a ‘high volatility’ year for ASX 200 shares.

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 course of 2020 below:

A-VIX chart and price data, year to date. Source: Google Finance

Does volatility matter?

Theoretically, an individual share’s volatility doesn’t make 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, not what the market might price it at different points of time.

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 of a share if it’s price moves sharply upwards, hoping to double-up on a winner. Otherwise, if a share’s price falls sharply, an investor may panic and sell-out, cementing a painful loss.

Both of these hypothetical decisions are emotional in nature and their potential can be exacerbated if a share has a history of volatility compared with the broader market.

In the end, volatility is something we all have to handle to varying degrees as a price of investing 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.