Of all the asset classes, equities are the most volatile. Stock prices can reverse course even in the middle of a trading session, turning what at first appears to be market gains into a loss. While volatility can be measured by the Chicago Board Options Exchange Market Index, which is an indication of the level of fear in the markets, it cannot be predicted. As a result, volatility can trigger unexplainable changes in the value of an investment portfolio.
When volatility in the equity markets causes drops of some 10 percent in an investment portfolio, it could motivate investors to abandon the stock market altogether, according to the consulting group of Morgan Stanley Smith Barney. Indeed, such volatility was not unusual during the economic recession of 2008, when the S&P 500 experienced price movements of more than 1 percent in more than 100 trading sessions -- far beyond normal levels. Nonetheless, the impact that equity volatility has on an investment portfolio is usually short-lived, as long-term investors have generally earned profits in the stock market since early in the 20th century.
Volatility is equated with erratic price movements in the stock market, and that's a fair assessment. Low volatility, however, is also a factor in the performance of an investment portfolio. When volatility is low, conditions are ripe for stock prices to rise in value, according to a 2011 article on the "Barron's" website; this increases the returns in an investment portfolio. Nonetheless, market volatility eventually stabilizes and the equity markets and investment portfolio values are again at higher risk of decline.
Volatility in the equity markets affects not only equities but all investments. It distorts asset allocation -- a road map of investment exposures meant to keep an investor on track so the percentage of assets directed to various asset classes shifts. When the equity markets are particularly volatile, it is likely to create a need for rebalancing, which realigns market positions by purchasing and selling securities to return an investment portfolio to target levels. Rebalancing can occur on a systematic quarterly basis, twice per year or when volatility causes a 10 percent movement in any asset class, according to a 2012 article on the "Forbes" website.
Extreme stock market volatility that caused the S&P 500 index to fall 38.5 percent in 2008 had lingering affects on professionally managed investment funds. Indeed, stock mutual funds lost $16.3 billion in assets under management in September 2012 alone as investors continued to shun signs of volatility in light of the 2008 economic crisis, according to a 2012 article on "The Washington Post" website. This benefited less volatile bond investment funds, which experienced a $31.6 billion surge in assets.
Video of the Day
- Drawing a stock graph image by Allen Penton from Fotolia.com