The stock market has been super volatile – How can I make sense of it?

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Takeaway
  • At its core, volatility is a measure of change.
  • Short-term investors might perceive volatility as a potential risk, but long-term investors don’t necessarily see it the same way.
  • Volatility can be heightened during times of uncertainty.

What makes the stock market move? On its face, that might seem like a simple question. Generally, many people buy and sell stocks, options, and ETFs, among other types of investments. On some days, there are more buyers than sellers, and on other days, it’s vice versa. Extreme volatility can occur for many reasons: A sudden swell of investor exuberance or despair (e.g., the dot-com bubble), underlying financial problems (the subprime mortgage crisis), or in response to a major disaster (like COVID-19). During these times of upheaval, it might seem like a different industry (or company) is under siege practically every day.

While it’s tempting to think of stock prices as a straightforward case of supply and demand, many factors actually drive the market, especially under the surface. Some influence specific industries or companies, like product recalls for contaminated vegetables or defective vehicles. Once in a while though, the entire market can get rocked. In a working paper published by the National Bureau of Economic Research, economists say that before COVID-19, no infectious disease had ever made a sizable contribution to US stock market volatility.

Regardless of whether you’re thinking about stocks for the first time or you’re a seasoned investor, understanding a bit about volatility can help you mentally prepare for the market’s unpredictability. Here are some basics.

What is volatility? How is it calculated?

At its core, volatility is a measure of change. In a financial context, that often means investors are asking, how much did the price of a stock change? And more specifically, how much does a stock’s price typically fluctuate? Many investors use standard deviation as a proxy for volatility.

A high standard deviation means that a stock has historically wavered significantly from its average price, a sign that investors might want to exercise caution. A lower standard deviation indicates that a stock’s price has historically been more stable, perhaps making it more appropriate for conservative investors. As always though, past performance is no guarantee of future results.

Volatility is kind of like turbulence during a flight...

You don’t know when it’s going to happen or how severe it will be. You can take steps to steel yourself when volatility strikes though. Just like passengers might return to their seats and buckle up, investors can conduct a personal review, making sure that they’re comfortable with how they’ve balanced their assets between cash, investments, and other individual needs.

Why does volatility matter?

Depending on an investor’s time horizon, they might prefer assets that provide less volatile returns. Oftentimes, people who plan to invest for just a few months or a couple of years, might select assets like certificates of deposit or treasury bills. For people with longer time horizons, though, short-term price changes probably aren’t as concerning. In the event of a decline, they’ll have more time to recover and potentially make up for any losses.

Short-term investors might perceive volatility as a potential risk. But long-term investors don’t necessarily see it the same way. In a 1996 letter to shareholders, Warren Buffett, the CEO of Berkshire Hathaway, wrote, “Charlie [Munger, my business partner] and I would much rather earn a lumpy 15 percent over time than a smooth 12 percent.” It can be difficult for investors to remain in stocks during prolonged downturns, and there’s no guarantee that stocks will return to their earlier levels. That said, the US stock market has traditionally recovered after recessions.

What does it mean when a person says “the market” is up or down?

Generally speaking, “the market” refers to some widely-referenced collection of US stocks. Examples include the S&P 500 Index and the Dow Jones Industrial Average. These are reference points, which can help investors check the pulse of the stock market.

Each index is constructed a bit differently—they’re made up of different companies and the exact numbers they reflect vary slightly. But, they essentially provide similar information: Investors want to know whether stock prices have risen or fallen across the board, and indexes can answer that question quickly.

Do indexes say anything about individual stocks?

It’s a mixed bag. Here’s the thing: Just because an index increased or decreased, that doesn’t tell you about the behavior of any one stock within the index. It’s more like asking if a basketball team won or lost a game. (That doesn’t tell you how many points each player scored.)

From one day to the next, the S&P 500 might fall 2% for example, but some of its components could still rise. The opposite could also be true. An index can rise while some of its components fall.

You might also think of an index like a cart full of groceries. The price of bananas, tortillas, and almond milk might increase, while the price of blueberry muffins might fall. Even if the overall cart has gotten more expensive, the prices of individual items might have dropped. Ultimately, on any given day, the market could be up or down, but whether your holdings are up or down depends on what’s in your portfolio (i.e., the assets you own).

Which industries have been hit by volatility in 2020?

The US stock market experienced an extraordinary period of volatility during early 2020 — Some volatility was even unprecedented, for example, when the price of oil futures turned negative (for the first time ever) or when companies like Amazon, Netflix, and Zoom hit all-time highs. The effects on the stock market haven’t been uniform. Many companies were battered, but there were a few bright spots.

Industries that can’t deliver goods or services in the midst of shelter in place and travel restrictions were badly disrupted. For instance, the aviation and tourism industries were hammered by COVID-19, analysts said. Tourism experts even projected that the US travel industry could lose $24 billion or more in foreign spending due to coronavirus.

But while some stock analysts have been pessimistic, there are others who remain upbeat. As companies research and develop coronavirus vaccines, some stocks in the pharmaceutical industry have rallied. At times, this has been short-lived, with clinical studies under dispute.

What factors might affect stock volatility going forward?

This is the guessing game at work, and it’s reflected by the huge variety of financial guidance that has been dispensed online. Some, including Apple CEO Tim Cook, reportedly anticipated a quick bounceback from the COVID-19 pandemic. But others, like Idaho farmers, thought the recovery would be slow and drawn out. Ultimately, we’re all acting with imperfect information and it’s entirely possible that a recovery (if one happens) could take longer in some sectors and take less time in other sectors.

Virtually anything can affect the stock market, from rising levels of unemployment to additional relief packages passed by Congress. A potentially rough earnings season could also throw a wrench into stock prices – Or perhaps a vaccine becomes available and none of that happens. How you approach volatility depends on your financial portfolio, what information you trust, and how you interpret your findings.

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