Investor uncertainty and stock market volatility defined the 4th quarter of 2018, as we experienced the first significant pullback in US stocks in nearly a decade. Not every year yields positive stock market returns, and at times, an entire year’s return can be reversed in a matter of months.
Yet, volatility is both a natural and necessary fact of investing in stocks. The adage, “no risk, no reward” still holds true as we put the 4th quarter in our rearview mirror.
Volatility is defined as how much variation there is in the price of a given stock or index of stocks; simply put, how widely a price can swing up or down. It is generally considered to be a measure of the level of risk in an investment. Typically, low volatility is associated with positive market returns and high volatility with negative market returns. However, volatility can be high when stocks are increasing or decreasing in value. It does not tend to be a focus in the news in a good market for obvious reasons.
We perceive the unpredictability of stock markets more acutely when volatility is higher than in previous periods. What better recent example of that than 2018! As you can see in the chart below, the previous year, 2017, was the first year in thirty years where there wereno negative monthsin global stocks, as measured by the MSCI All World Stock Index (ACWI).
Investors can be lulled into complacency about stock market risk in such low volatility environments. 2018’s market movement felt more extreme than it otherwise would have, because it followed on the heels of the extraordinarily placid 2017 market. How might we put that into perspective and understand when volatility is above normal levels?
Standard deviation is a quantitative measure that can serve as a proxy for volatility. The higher the standard deviation, the higher the variability in market returns. The graph below shows historical standard deviation of annualized monthly returns of large US company stocks, as measured by the S&P 500. Volatility averages around 15%, is often within a range of 10-20%, and rises and falls over time. More recently, volatility has risen off historical lows, but has not spiked outside of the normal range.
Can we extrapolate these movements or draw conclusions about the future? Perhaps. What we do know is that extreme events tend to be mean-reverting. In other words, when volatility is at historical lows, we can expect it to rise at some point towards the long-term average. The inverse is also true; when volatility is well above average, we can expect it to fall in the future.
Volatility is a normal characteristic of investing in stocks. The reward is that over time, stocks have delivered a higher average return than most other asset classes. Recognizing this tradeoff helps us stay the course when stock prices are fluctuating.
I'm an experienced financial analyst with a deep understanding of investment strategies and market dynamics. My expertise in financial markets, risk management, and investment analysis allows me to provide valuable insights into the topics discussed in the article authored by Rachel A. Rasmussen, CFA.
Rachel's article delves into the crucial concepts of investor uncertainty and stock market volatility, particularly focusing on the notable events of the 4th quarter of 2018. As an enthusiast in the field, I appreciate her emphasis on the significance of volatility as a natural and necessary aspect of investing in stocks.
The article rightly acknowledges that not every year guarantees positive stock market returns, and the occurrence of significant pullbacks, as seen in 2018, serves as a reminder of the inherent risks in the market. The adage "no risk, no reward" aligns with the core philosophy of investing, emphasizing the need to accept volatility as an integral part of the investment journey.
Volatility, as defined in the article, is the measure of the variation in the price of a given stock or index, reflecting the extent to which prices can fluctuate. It serves as a crucial indicator of the level of risk associated with an investment. The article rightly points out the general association of low volatility with positive market returns and high volatility with negative market returns. However, it also highlights the nuanced nature of volatility, noting that it can be high in both increasing and decreasing market scenarios.
To quantify volatility, the article introduces the concept of standard deviation, a quantitative measure that serves as a proxy for volatility. The historical standard deviation of annualized monthly returns of large US company stocks, as measured by the S&P 500, is presented in a graph. This visual representation helps readers understand the variability in market returns over time, with volatility typically ranging between 10-20%. The recent rise in volatility from historical lows is noted, but the article wisely advises against drawing hasty conclusions about the future.
The concept of mean-reversion is introduced as a key aspect of understanding volatility. When volatility is at historical lows, the article suggests an expectation of its eventual rise toward the long-term average. Conversely, when volatility is above average, a future decrease is anticipated. This insight into mean-reversion adds a valuable dimension to understanding the cyclical nature of market volatility.
In conclusion, the article emphasizes that volatility is a normal characteristic of investing in stocks and underscores the long-term rewards that stocks have historically provided, outperforming most other asset classes. This perspective encourages investors to stay the course even during periods of fluctuating stock prices.
