The stock market fluctuates on a daily basis, and with each change in price there are stock winners and losers. Too much volatility means that there is uncertainty in the market -- not good for investors. Professional investors attempt to insulate their portfolios from volatility by diversifying their investments so that if one stock declines in value another stock picks up the slack.
Stock Market Volatility
Price changes in the stock market are a reality. The stock market is a broad measure of the economy and is affected by many variables, such as interest rates, inflation and geopolitical events. To help investors measure volatility, the Chicago Board of Options Exchange introduced the Volatility Index, called VIX. The VIX tracks the speed of stock price movements in the S&P 500. The CBOE's NASDAQ Volatility Index, or VXN, measures the speed of price movements for technology stocks.
The VIX is quoted in percentage points and represents the expected movement in the S&P 500 over the next-30 day period annualized. It is the measure of the market's perceived volatility. If the reading is 10, this translates into an expected annualized change of 10 percent over the next 30 days. This means that the market expects the S&P 500 to move up or down over the next 30-day period by 2.9 percent, which is 10 divided by the square root of 12. A high VIX doesn't necessarily indicate that the stock market will reverse course and decline suddenly. However, a high VIX reading is an indication that investors anticipate huge movements in the stock market.
Every individual stock has a perceived measure of volatility as it relates to the overall market. This is the unique risk inherent in every stock, such as management of the company making a bad business decision or suffering a sudden downturn in its business outlook. Beta is the measure of volatility of a security or a portfolio in comparison to the market. Beta is also referred to as systematic risk. Beta uses regression analysis of a stock's returns and compares it to the returns of the stock market. A beta of 1 means that the stock is exactly as risky as the market. A stock with a beta of 2 is twice as risky as the market. That means if the stock market declines by 10 percent, the stock has the potential to decline by 20 percent or more. On the other hand, a stock with a beta of 2 has a greater chance of outperforming the market.
Seasoned investors shy away from volatility by diversifying their portfolio holdings. For example, if you own a technology stock, investing in a utility stock or food and beverage company act as a counterbalance in case the technology stock suddenly declines in value. Experts disagree on the number of stocks to include in your portfolio to diversify volatility or risk, but it should be enough to produce stable returns by reducing the likelihood of severe ups and downs in the portfolio.
- CommonWealth: What's Stock Market Volatility
- CBOE: Volatility Indexes at CBOE
- CBOE: The CBOE Volatility Index - VIX
- Vanderbilt University: Derivatives on Market Volatility: Hedging Tools Long Overdue
- U.S. Securities and Exchange Commission: Beginners' Guide Asset Allocation, Diversification and Rebalancing
- CBSNews: Do High-Beta Stocks Produce Higher Returns?
- Stock quotes image by Chad McDermott from Fotolia.com