But while price swings are a common phenomenon in most asset classes that exist, they are the most famous in the stock market. These upward and downward movements in price are known as volatility, which is defined as “a measure of the frequency and severity of price movement in a given market”.
Understanding Volatility
Today’s infographic comes to us from Fisher Investments, and it serves as an introduction to the concept of volatility, along with offering a perspective on volatility’s impact on investments. Why are certain times more volatile than others? In the short term, volatility is driven by changes in demand, which is largely related to changes in earnings expectations. These expectations can be affected by:
Earnings reports New economic data Company leadership changes New innovations Herd mentality Political changes Interest rate changes Market sentiment swings Other events (economic, political, etc.)
Often the media and investors assign certain narratives to price changes, but the reality is that the stock market is very complex, and has many underlying factors that drive movements. What ultimately matters for volatility is demand: if stocks move up or down on a given day, we can say definitively that demand for stock was more (or less) than stock supply.
Calculating Volatility
Technically speaking, volatility is a statistical measure of the dispersion of returns for a given security or market index over a specific timeframe. In other words, two stocks may have the same average rate of return over a year, but one may have daily moves of 1%, while the other may jump around by 5% each day. The latter stock has a higher standard deviation of returns, and thus has higher volatility. Here’s what you need to know about standard deviation, which is a common measure of volatility:
Roughly 68% of returns fall within +/-1 standard deviation To calculate standard deviation, differences must be squared. This means negative and positive differences are combined Standard deviation tells you how likely a particular value is, based on past data Standard deviation doesn’t, however, show you the direction of movement
This all gets more interesting as we look at the market as a whole, in which thousands of stocks (each with their own individual volatility) are moving up and down simultaneously.
Market Volatility
Now that you can see how volatility plays out with individual stocks, it makes sense that market volatility is the overall volatility from the vast collection of stocks that make up the market. In the United States, the most watched stock market index is the S&P 500 – a collection of 500 of the largest companies listed in the country. One measure of the volatility of the S&P 500 is the CBOE Volatility Index, or as it is known by its ticker symbol, the VIX. Volatility and market sentiment in the overall market are important, because humans tend to experience the pain of loss more acutely than the upside of gains – and this can impact short-term decision making in the markets. Negative price swings in the wider market can be distressful and unnerving for investors, and high volatility does present some challenges:
Uncertainty in the markets can lead to fear, which can lead investors to make decisions they may otherwise not make If certain cashflows are needed at a later date, higher volatility means a greater chance of a shortfall Higher volatility also means a wider distribution of possible final portfolio values
That said, volatility also represents a chance of better returns than expected – and for long-term investors that are patient, volatility can help drive outcomes. on Last year, stock and bond returns tumbled after the Federal Reserve hiked interest rates at the fastest speed in 40 years. It was the first time in decades that both asset classes posted negative annual investment returns in tandem. Over four decades, this has happened 2.4% of the time across any 12-month rolling period. To look at how various stock and bond asset allocations have performed over history—and their broader correlations—the above graphic charts their best, worst, and average returns, using data from Vanguard.
How Has Asset Allocation Impacted Returns?
Based on data between 1926 and 2019, the table below looks at the spectrum of market returns of different asset allocations:
We can see that a portfolio made entirely of stocks returned 10.3% on average, the highest across all asset allocations. Of course, this came with wider return variance, hitting an annual low of -43% and a high of 54%.
A traditional 60/40 portfolio—which has lost its luster in recent years as low interest rates have led to lower bond returns—saw an average historical return of 8.8%. As interest rates have climbed in recent years, this may widen its appeal once again as bond returns may rise.
Meanwhile, a 100% bond portfolio averaged 5.3% in annual returns over the period. Bonds typically serve as a hedge against portfolio losses thanks to their typically negative historical correlation to stocks.
A Closer Look at Historical Correlations
To understand how 2022 was an outlier in terms of asset correlations we can look at the graphic below:
The last time stocks and bonds moved together in a negative direction was in 1969. At the time, inflation was accelerating and the Fed was hiking interest rates to cool rising costs. In fact, historically, when inflation surges, stocks and bonds have often moved in similar directions. Underscoring this divergence is real interest rate volatility. When real interest rates are a driving force in the market, as we have seen in the last year, it hurts both stock and bond returns. This is because higher interest rates can reduce the future cash flows of these investments. Adding another layer is the level of risk appetite among investors. When the economic outlook is uncertain and interest rate volatility is high, investors are more likely to take risk off their portfolios and demand higher returns for taking on higher risk. This can push down equity and bond prices. On the other hand, if the economic outlook is positive, investors may be willing to take on more risk, in turn potentially boosting equity prices.
Current Investment Returns in Context
Today, financial markets are seeing sharp swings as the ripple effects of higher interest rates are sinking in. For investors, historical data provides insight on long-term asset allocation trends. Over the last century, cycles of high interest rates have come and gone. Both equity and bond investment returns have been resilient for investors who stay the course.
