Why is the share market so volatile?

Why is the share market so volatile?

If you’ve spent any time watching the share market, you may have noticed that share prices can move up and down a great deal in a day. 

You might also observe other periods when prices remain relatively stable. And, after a while, you’ll probably also see that some share prices fluctuate more than others.

Scared looking people on a rollercoaster ride representing the volatile Mineral Resources share price in 2022
Image source: Getty Images

The term we use to describe the degree to which market prices move about is ‘volatility’. Mathematically, it is captured by a share’s standard deviation of returns, which is a measure of dispersion around the mean (or average) price. Put simply, it is just a representation of how much a share price changes from one period to the next.

A company with a share price that changes a lot each day – particularly where the magnitude of those changes appears to be random – would most likely have a higher standard deviation. It would be considered more volatile than a company with a relatively stable share price or one that increases (or decreases) by a steady rate over time. 

Similarly, periods in which the overall market delivers a steady return are less volatile than periods in which the daily swings in market prices are more pronounced.

Looking at the beta metric on online share trading platforms is one way to quickly identify how volatile a share is compared to the market. A high-beta share of greater value than 1 tends to be more volatile than average, while a low-beta stock (lower than 1) tends to be smoother or less volatile.

You can imagine the share market almost like an ocean – when the weather is rough and the water choppy, it is more challenging to navigate your ship to shore. But when the waters are calm, sailing is much easier.

It’s much the same when we talk about market volatility. Things become riskier and more challenging to predict when trade is choppy. We would all prefer calmer waters in which to build our wealth safely.

Unfortunately, it can’t always be that way. When we venture out into the share market, we often face multiple storm fronts at once. So, before we push this metaphor past its breaking point, let’s have a look at some of the reasons why markets can be so volatile and how you, as an investor (or sailor?), can safely weather the storms.

A history of volatility

We don’t have to go too far back in time to find examples of extreme volatility. In the past 25 years, financial markets have suffered through the dot-com bubble of 1999, the 2008 global financial crisis, and most recently, the 2020 market crash driven by the COVID-19 pandemic. And wedged between these significant market events have been shorter periods of volatility including corrections and flash crashes.

This tells us that market volatility is pretty standard – and possibly becoming more frequent. So, although these periods of heightened volatility may cause us stress and anxiety, we should understand them to be a natural part of the market cycle and prepare accordingly.

Let’s put some of these price moves in perspective. A market correction – commonly defined as a drop in prices of more than 10% but less than 20% – generally occurs once every one to two years.

A bear market – when the market falls by more than 20% – comes along roughly once every four to five years. In short, if you’re a reasonably young investor building a portfolio for your retirement, you’re going to experience quite a few major market events during your lifetime.

This is likely to include the ‘black swan’ – a rare and unexpected event that can have severe and even catastrophic effects on financial markets. The term was popularised by former Wall Street trader Nassim Nicholas Taleb, who recommended that, as these events can’t be foreseen, investors should assume one is just around the corner and make plans to reduce its potential impact on their portfolios.

Strategies for investors to safeguard against severe, short-term volatility include constructing a diversified portfolio, or following a dollar-cost averaging investment strategy (which essentially means diversifying your investments across time).

However, it’s worth mentioning that despite the frequency of market corrections, the share market continues to deliver pretty exceptional returns over time. According to S&P Global, the S&P/ASX 200 Index (ASX: XJO) has delivered an annualised return of 6.21% over the past 10 years – including the 2020 COVID-19 crash. 

This means if you had invested $10,000 in the 200 largest companies on the ASX 10 years ago, your investment would now be worth about $18,266 (assuming you reinvested all your dividends).

In other words, the value of your investment would have almost doubled in 10 years! There aren’t too many assets out there that can deliver that sort of return.

What causes share market volatility?

At its core, market volatility is driven by the economic forces of supply and demand. If demand increases or supply decreases, prices will tend to rise. If demand decreases or supply increases, prices will tend to fall. 

Volatility occurs when the push and pull forces of supply and demand change frequently, sometimes by significant degrees. When this happens, the uncertainty makes it harder for the market to agree on the price of shares.

Many factors can contribute to market volatility, often simultaneously and at varying market levels. For example, macroeconomic forces may lower the global demand for equities – and yet an individual company might release positive news that boosts demand for its shares relative to others. 

In this situation, making accurate predictions about what might happen to that company’s share price becomes quite difficult.

Macroeconomic events

As mentioned, macroeconomic events can have implications for the share market. Macro events include wars, trade disputes, geopolitical tensions, global pandemics, and other major disasters.

In these situations, investors may seek out less risky investments like government bonds or gold – so-called ‘safe-haven assets’. As a result of the cumulative actions of individual investors, the price of riskier assets like shares might fall while the price of gold and high-quality bonds goes up. This simply reflects demand shifting from one market to another.

However, macroeconomic events don’t necessarily need to be so destabilising. Prevailing interest rates, currency valuations, levels of inflation, and the prices of essential commodities, such as oil, can all influence the markets in various ways.

For example, central banks may lift interest rates to curb inflation, but this can also dampen business growth. Businesses won’t borrow as much when interest rates are high, so they will undertake fewer expansion projects.

Industry-specific headwinds

In addition to macroeconomic events, there are industry-specific headwinds that affect specific sectors of the market in isolation. For example, if we delve more deeply into the impact of COVID-19 on the ASX, we can see that specific sectors have outperformed (or underperformed) others.

Border closures and extended lockdowns have particularly hurt the market’s travel and retail sectors. However, these same government measures have increased business – and profits – for some technology companies that provide the infrastructure necessary for remote workers.

Outside of the pandemic, we can find other instances of industry-specific headwinds. For example, changing rules and regulations in the buy now, pay later (BNPL) space have resulted in volatility across those company share prices.

Company-specific decisions 

Companies release regular updates to the share market. These include financial results, business progress reports, and announcements of mergers and acquisitions.

Investors use these announcements to decide whether or not to invest in these companies. A surprise positive earnings result may increase demand for a company’s shares, while reports of company leadership changes may concern investors and cause them to sell their shares, driving the share price down.

As you can imagine, all manner of different company announcements can affect share prices in different ways.

Bringing it all together

Hopefully, this brief discussion of share price volatility has illustrated how difficult it can be to predict market behaviour. It’s possible to have contradictory macro, industry, and company-level events all happening simultaneously. Trying to parse their various potential effects on share prices is incredibly complicated.

Then add to the mix the fact that markets can sometimes behave irrationally – overreacting to specific pieces of news while completely ignoring others. So, even when you identify the events that might drive market volatility, it still doesn’t guarantee that you will accurately predict how investors will behave as a collective.

What else drives share market volatility?

Many different investors participate in the share market, each with their own investment goals and strategies. And they can each contribute to price volatility in different ways.

Momentum traders, for instance, look for shares that are on the rise – buying them on the way up and then attempting to sell them at the moment their prices peak. These investors try to use market volatility to their advantage by identifying short-term trends in market prices.

However, when this type of investor acts in concert with one another, the collective can increase market volatility by creating asset price bubbles. Sooner or later, these price bubbles will burst, sending prices tumbling again. By latching onto volatility, momentum traders can magnify its effects.

In contrast, value investors look for shares that have been oversold by the market. These might be well-established companies receiving bad publicity or operating in a struggling industry. Value investors can drive up the price of cheaper shares, often helping to keep companies’ share prices more in line with their underlying valuations.

There are many other types of investors out there, too: dividend investors, growth investors, ‘buy the dip’ investors, and all sorts of day traders. Large institutional investors can also contribute to market volatility by buying or selling substantial shares in a single transaction.

Here at the Fool, we encourage investors to take a long-term approach to investing. That way, you don’t have to be so concerned about short-term share market volatility. 

The problem with momentum trading and other short-term investment strategies is that an enormous amount of skill (and luck!) is required to implement them properly. And, even when they pay off, they still tend not to deliver as strong a return over time as long-term investment strategies.

How can I stay calm during share market volatility?

On the surface, market fluctuations can seem unpredictable, frightening, and often downright confusing. But it’s important to tune out the noise and focus on what matters most: growing wealth over time. This means that we shouldn’t be overly concerned about short-term price movements. It’s important to remember that the share market has consistently generated strong average annual returns over time.

Try to look past daily market movements, currency fluctuations, or confusing macroeconomic events. Many of these elements can be challenging for even seasoned economists to interpret – it’s only natural that they might seem like incomprehensible hieroglyphics to the rest of us!

Also, wise investors try to take the emotion out of investing by not overreacting to current events. This doesn’t mean that you can’t take advantage of short-term opportunities where they present. Just ensure your investment decisions are well thought out and not simply following the latest fad.

It’s also wise to ignore the short-term headwinds that might challenge the companies you have invested in. Traders with shorter time horizons are more likely to jump ship at the first mention of any obstacles to business growth. As long-term investors, we have the time to let solid companies overcome these challenges.

So, instead of getting anxious over short-term price fluctuations, focus on the underlying fundamentals of a company. Learn how to read and interpret their financial statements. And regularly invest when possible to capture the benefits of compounding.

If you keep these things in mind, short-term market volatility won’t be anywhere near as stressful, and you can instead think about how you’re going to spend your wealth in retirement.

Last updated June 2022. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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