Volatility and your Portfolio
Return volatility is a measure of the variation (the highs and lows) of a stock’s price returns over time. As a measure of risk, volatility indicates how much and how quickly the price of an investment can change. Volatility is calculated as the standard deviation of historical investment returns from their expected return. Said another way, it is defined “as a statistical measurement of how much an investment’s returns will deviate from its average.” Return volatility, as measured by standard deviation, is the risk that an investment will not meet its expected return over a given period of time. The smaller an investment’s standard deviation, the less volatile or risky it is perceived to be. The larger the standard deviation, the more scattered the return outcomes, and the investment is considered more of a risk to investors. It is important to remember that standard deviation is not a relative measure which means that it is best used only when in the context of a comparison of similar or like securities or with a compatible benchmark.
Is return volatility then good or bad? Depends. With higher volatility comes a diminished ability of the investor to accurately predict the expected return of an individual stock or a portfolio of risky assets. The trade-off here is that with higher volatility often comes the potential for larger share price gains. In the short term, while the wider range of investment outcomes presents a challenge to investors, in the long term those same challenges may be viewed more as an opportunity. While many investors view volatility as a negative, many analysts and fund managers often see an increase in volatility, especially after a period of calm, as signaling an identifiable change in direction. Volatility is not a risk for long term investors like political or economic risk, or industry or sector risk or even company performance. When the price of a stock falls, it is normal to think that something has changed for the worse – while that will happen sometimes, it may be the exception and not the norm. Most volatility does not lead to a permanent loss of capital, rather it should be considered just the normal result of market activity.
Market volatility is measured by the CBOE Volatility Index or VIX. The VIX, one of the most widely watched gauges of expected near-term market volatility, is a measure of the cost of buying options on the S&P 500 Index one month in the future. Often called the “fear gauge”, the VIX derives expected volatility by averaging the prices of out-of-the-money puts and calls. Although the VIX formula includes both puts and calls, it is the increased demand for puts that has a greater impact on the result. A rising VIX signals an increase in put option activity, which often means that institutional investors have become nervous about the stock market and are looking to hedge (protect or insure) their holdings from a broad market decline. Thus far in 2024, we have seen a wide range of VIX values between 11.78 and 38.57 (August 5th), compared to the long run average value of about 20. On that date (August 5th) the VIX jumped almost 70%. It should come as no surprise that VIX was highest in early August as the market experienced both a deep sell-off in the “magnificent seven”, a drop in US oil prices and the now fleeting revisiting of a potential US recession. From that point, the VIX has dropped steadily back to its current reading of 13.5, with slightly elevated readings coming in October in the run up to the US Presidential election. Investors who purchased the S&P 500 (SPY) on August 5th, when the VIX was at its 2024 high mark, have been rewarded for their insight with a current gain over +16%. In closing, let’s remember the old saying “When the VIX is high, is it time to buy?”