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What does market volatility mean?

When financial markets fluctuate, we often refer to this as volatility. But what precisely do we mean by market volatility? This article takes a close look.

Published on 24 Aug 20225 minute read

Written by Tom White

Volatility is the degree to which asset prices move over time. When we talk about volatility, it’s generally equity market volatility we’re concerned about. Equity prices can be highly volatile, and this can be unnerving for novice investors – how can a company with the same factories and the same employees be worth 10% less today than it was yesterday?

We can get a rough idea of volatility by looking at a chart of stock-market performance and seeing how much it has moved up and down. Consider two recent years, 2017 and 2020. Returns for global equities were similar in both years: +12.4% in 2017 and +12.9% in 2020. However, they delivered those returns in different ways. As we can see from the chart below, in 2017 the market rose fairly steadily, whereas in 2020 it dropped sharply and then recovered – it was more volatile.

In investment rather than rely on eyeball judgements like this, we find it helpful to summarise the level of volatility in a number. We generally use the annualised standard deviation of returns – the higher the figure, the more the asset price has moved around.

And this number can also be applied to other asset classes. Cash is the ultimate low-volatility asset – your bank balance stays steady, and if you’re lucky accumulates some interest. Other asset classes such as bonds or infrastructure typically occupy an intermediate point between cash and equities, but that’s not always the case. Commodities such as gold or oil can be even more volatile than equities.

Why are equities volatile?

At the simplest level, the price of an equity is determined by its profits – the more money it makes, the more it is worth. Profits are dependent on revenues – how much of its products and services a company is selling across different markets – and costs, such as raw materials, staff wages and taxes. But even a company as well-known as Unilever sells more than 400 brands in 190 countries round the world – changes in any one of these could affect its profits. Quickly what seems like a simple calculation has become complex.

And prices are determined not just by current profits, but also the future direction of those profits. A fast-growing company like Tesla can attract a high share price based less on its performance now, but more on the expectation that its pioneering-electric cars will bring higher profits in the years to come.

By introducing future profits, we also bring in forecasts and hence the skill and emotions of human investors. They can buy or sell shares whenever they change their forecast, change their mind, or even because they simply need the money. And those buys and sells can move the share price, causing volatility.

Why has volatility increased?

An important thing to know about volatility is that it is itself volatile. This is demonstrated in the chart below, which shows market volatility over the last 20 years. While equities have been consistently volatile, levels of volatility spiked up noticeably at certain times, most notably during the global financial crisis from 2008-2009 and during the pandemic between 2020-2021.

This is because in addition to the factors affecting individual companies, there are numerous economic factors like GDP growth, inflation and interest rates that affect all companies to a degree. When these factors change, they often move the whole market, sometimes substantially.

To take a simple example, if economic growth slows, that’s likely to reduce profits for companies across the market. It might hit some companies more than others, but in aggregate it will cause the market to fall.

We saw this during the pandemic. Share prices began to collapse in February 2020 with the onset of the virus and fears over its impact on businesses. However, they quickly saw a sharp recovery after the introduction of government support measures such as furlough schemes. They then reacted sharply to negative news such as lockdowns, or positive news such as the approval of vaccines.

This is what really leads to high volatility – not just a large rise or fall in the market, but constant reversals as investor emotion switches back and forth in reaction to changing economic news.

Find out how to manage your investments when markets are volatile

If you’re keen to find out more about how to manage your investments during volatile times, we have a free guide to help. You can download your copy of Managing investments through challenging times – a guide to coping with market volatility now.

Download now

Please see the Important information below.

Important information

By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

The value of an investment may go down as well as up and you may get back less than you originally invested.

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