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What is market volatility?

Have you ever experienced turbulence on an airplane after a relatively smooth flight? From the bumps and jolts down to the nerves you feel, this can be what market volatility feels like. If you’re investing in stock markets, whether you are a short-term trader or long-term investor, you will likely see and experience volatility and uncertainty in the markets you are investing in.

What is volatility?

Market volatility is the magnitude or range of the change in a market, compared to what is an average performance for the same market. It’s usually characterized by sharp rises or falls in market performance. Measured by the standard deviation of the return on investment, volatility can range from being very volatile – which would see a high standard deviation, to stable – which would see a standard deviation closer to 0.

What creates market volatility?

It’s completely natural for markets to have volatility. There are various factors that can cause volatility, and while it’s helpful to understand some of the main factors that can cause volatility, practically anything can cause it. Earnings reports and IPOs can create minor volatility, while larger events such as U.S. interest rate hikes, pandemics (as we are currently experiencing with the COVID-19 pandemic), large weather storms, political unrest and trade wars can create larger volatility.

What is Emotional Intelligence?

Emotional intelligence, defined by Peter Salovey and John Mayer, is “the ability to engage in sophisticated information processing about one’s own and others’ emotions and the ability to use this information as a guide to thinking and behavior.” Volatility can create a range of emotions for investors, from excitement and nervousness to fear, and you may notice that your emotions can cloud your judgement. It will take discipline to be able to manage your emotions during market volatility and stay laser focused on your long-term goals.

How does volatility impact my portfolio?

Market volatility can have an impact on your portfolio, and depending on your asset allocation and diversification and the intensity of the volatility, the amount of impact it can have on your portfolio ranges.

That’s why it can help to diversify your portfolio not only by type of equities, but also by type of assets, including stocks, bonds, commodities and cash-equivalents.

Market volatility can even impact trading in certain instances. It can cause delays because of the high volumes of trading, digital issues with trading systems because of the high volumes, or incorrect quotes because the market may be changing rapidly. To help offset some of these risks, you might choose to utilize a limit order when trading, which is an order for a predetermined amount of shares at a specific price.

There may be extreme cases where you might see unprecedented market volatility, such as during the current COVID-19 pandemic. The markets plummeted in March 2020 and countries around the world have been in and out of lockdowns. The S&P 500 rebounded since it’s 33.8% drop in March, but unemployment rates are still at record highs and U.S. interest rates continue to hover at their lowest point since the 2008 financial crisis.

What can I do to protect my portfolio from volatility?

When you encounter volatility, remember to stay calm. Take a step back and relook at your portfolio and ensure you have the right diversification to minimize your risk as best as possible. Good leadership, strong balance sheets and strong track records may be good indicators that a company will be able to weather the storm. As stock prices decline, you might feel that this can actually be a good time to buy shares in a company that you have always wanted but haven’t had the chance to because of high share prices before the volatile market. But, only “buy the dip” if you believe that the stock price will recover over time and you are a long-term investor.

With market swings and volatility, some investors strategically try to sell before the market declines too much, and then buy on the market upswing. Since it’s nearly impossible to time the market, this never usually works in any one’s favor. Trends are difficult to spot when the market is extremely volatile and this could cause emotions to take over and traders to make bad investment choices, which can cause investors to lose too much and miss out on the potential growth that comes with an upswing. If you are a long-term investor, you might feel that this instance can be avoided altogether by holding on to investments throughout a period of volatility to ride out the storm.

Typically for day-trading purposes, inverse ETFs perform opposite of what the market is doing, allowing investors to potentially offset the volatility. Inverse ETFs profit from a decline in the value of its underlying benchmark. During the most recent bear market between February and March 2020 where the S&P 500 dropped by 33.8%, the best inverse ETF based on total return was the ProShares Short Russell 2000 (RWM).

It’s never guaranteed that stock prices will return to their previous levels during market volatility, but historically, the U.S. stock market has recovered after periods of downturns. To that end, it’s important to always keep your emotions in check and anticipate market volatility as best as you can by understanding what causes volatility. It’s natural to experience volatility while investing in the stock market and the better you can anticipate it and plan for it with diversification and staying calm, the better outcome you will see. If you do choose to trade during market volatility, ensure that you understand and remember the risks.