Why you should care about volatility (but not too much)

Many stocks that are prone to sudden gains are liable to rapid losses too.

That’s the basic idea behind volatility, which is the difference between the highest and lowest prices of any given security. The higher a stock’s volatility, the riskier it is to own. That’s because you could lose money more quickly than you would with other investments. The reverse is also true—the price of the security could also rise more quickly.

A volatile stock might behave like someone who’s had too much to drink—swerving unpredictably as he walks home. Similarly, a high-volatility stock’s prices often move uncontrollably and irrationally.

A low-volatility stock, on the other hand, would behave like a sober person, travelling in a relatively straight line and only deviating for normal reasons (to pick up milk, for instance). Similarly, this type of stock’s prices would usually move rationally, in line with changes in the company’s intrinsic value.

It’s difficult to predict how volatility will impact the price of a particular security. It’s also difficult to predict when markets will be hit by greater volatility. “Market volatility tends to come in a sudden and quick spike,” explains Peter Christoffersen, professor of finance at the Rotman School of Management. “And those spikes are often driven by things we don’t expect, such as political risk or sudden changes in oil prices.”

Volatility also comes and goes—it might increase suddenly, but could take a long time to come back down again, he says. “Because volatility hits the market in a sudden spike, it recedes very slowly,” Christoffersen explains.

No one can predict which events will move markets and how. But one way to gauge market volatility is through the Chicago Board Options Exchange Volatility Index (the VIX), also referred to as the fear gauge. The VIX tracks the prices of options, which are contracts that give investors the right to buy or sell securities on specific dates, at specific prices. These contracts become cheaper or more expensive based on how sure people are that they’ll use them.

In short, the VIX gauges how investors feel about the broad market today and how they might feel about it in the future.

A VIX reading of more than 30 typically means there’s much volatility in the market. In times of extreme uncertainty it can go even higher – in 2008, the VIX was over 80. In contrast, a value of less than 20 would indicate a more stable market.

Volatility and your investments

Stocks do better than bonds in times of low volatility—but higher volatility is great for bonds, which typically have relatively higher returns during a volatile market, notes Christoffersen. During periods of high volatility, the value of bonds doesn’t fluctuate as much as the value of equities. That’s because fixed-income returns are affected by longer-term trends such as interest rate changes.

During times of higher volatility, you can also look to other investments to steady your portfolio such as real estate investment trusts (REITs), infrastructure or private equity funds. There are also many “low volatility” funds that aim to outperform during times of higher volatility by choosing stocks that perform well in choppy markets (for instance, utilities and consumer staples).

Volatility and you

So should volatility keep you awake at night? No, says Keir Clark, a senior wealth advisor and associate portfolio manager with ScotiaMcLeod. Volatility creates opportunities for patient investors “who [can] tolerate uncomfortable times and rebalance at difficult moments,” he explains.

Hold on to your investments. Why? “If you priced your house daily based on what it would sell for any given day, you would see volatility,” Clark says. “But over time the value [usually] goes up.” Day-to-day volatility doesn’t mean you should dump your investment.

You should ask your advisor how your portfolio would likely behave in volatile conditions. “You need to be comfortable with the mix of stocks and bonds in your portfolio,” Christoffersen says. “The more equities it has, the more volatility it has,” while bonds help smooth out performance. In the long run, people with more stocks in their portfolio have higher returns, but they have to be able to live with the volatility.

Clark picks blue chip stocks, which tend to have consistent performance. While they might underperform when markets are racing ahead, they do better when markets are falling, he says.

What now?

Both Clark and Christoffersen say investors need to gird themselves for more volatility than we’ve experienced in the last few years. America’s central bank is winding down its quantitative easing program. For the past few years, QE has pumped billions of dollars into the market, pushing stock prices up. Negative macro-economic news, such as poor growth in China or Europe, will also fuel volatility. But that’s not a bad thing—it’s actually normal. Usually, says Clark, markets go up 75% of the year and are down the rest of the time.

You should care about volatility and how it could impact your portfolio. Just don’t care too much; volatility might drive prices down, but it’ll eventually lead them up again.