WTF Is Market Volatility?
Up until February 9, those of us fortunate to have money invested in the stock market were feeling great about our expanding account balances.
The U.S. stock market, like the Energizer Bunny, grew a robust 22 percent in 2017. And just in January alone, the market rose another six percent. On cue, investors got cocky. Some idiots went as far to proclaim on social media that they’d achieved millionaire retirement-savings status. Others who hadn’t invested in years decided to join the party (way too late) for fear they may miss the boat to newfound wealth.
But that boat now is in trouble. The stock market fell 10 percent last week, $2 trillion in wealth wiped out during one of the most violent five-day roller-coaster rides in market history.
That’s what we call market volatility.
What Causes Market Volatility?
The stock market mirrors the collective hopes and fears of individual investors — big and small, rich and not so rich. If investors are optimistic, the market will most likely perform well. On the other hand, if everyone expects the end of the world… well, you get the picture.
What really drives market volatility? Three broad areas investors fixate on most: corporate profits and losses, rising and falling interest rates, and geo-political events.
This recent bout of volatility stems from worries about rising interest rates, which makes the cost of borrowing money (through financial tools like mortgages or credit cards) more expensive.
When investors start to lose confidence and grow more fearful, the most risk-averse start selling.
And that can turn into a snowball that drags everyone down.
The Physics of Market Volatility
We all love the thrill of watching our account balances grow month after month, year after year. We expect that, with the added expectation that there could be some small inconsequential dips along the way.
But when the market falls dramatically and frequently, then we have volatility — the deviation from what stock market investors expect (growth). When volatility takes hold, as it did last week, it typically spikes before it dampens down.
Think of a vibrating guitar string: Initially after a good pluck, the oscillation is strong and fast. But eventually the vibration will stop.
Luckily, the big brains who run the stock market have ways to minimize volatility when it kicks in.
Can We Measure Volatility?
Those big brains also created the Chicago Board Options Exchange Volatility Index, commonly called the VIX, to gauge the stock market’s anxiety or fear levels. How the VIX works is a bit complicated, so I’ll keep it simple: There’s a secondary stock market in which some investors (basically rich, sophisticated busy bees) can make fast money by placing risky bets, or “options,” on whether certain stocks will rise or implode in price. The VIX basically predicts the behaviors of these “option” investors over the next 12 months.
How Should Investors Act When Volatility Strikes?
First of all, investors should be prepared for bouts of volatility. They’re a fact of life. That means you should diversify, or invest your money — whether for retirement, your kid’s college education, or that Costa Rica trip — in a lot of different things, like the stocks of both big and small companies and bonds issued by governments and corporations.
And during times of volatility, keep calm and carry on. Be mindful that most bouts of volatility are short-lived. If you’re smart and have the means, you should be investing regularly over months, years, and decades through market ups and downs. Just don’t try to time the market. Steady Eddie (i.e. long-term investing) always wins the day.
Can Market Volatility Be a Good Thing?
Of course. This is what’s called a buying opportunity. When the stock market declines and stock prices become cheaper, you can obviously buy a larger number of your favorite stocks at lower prices.
In fact, this is exactly what I did 10 years ago during the financial crisis, when the stock market crashed hard and trillions of dollars of wealth vanished between September 2008 and March 2009. It was volatility on steroids. But through this time, I never panicked. I kept buying when I could. Don’t get me wrong: Those were harrowing times. Watching my account balances shrink was depressing. But I knew in my heart the market would come back – and it did.
Market volatility sucks. Losing money sucks. But instead of looking at volatility as a curse, look at it as an opportunity. It keeps us honest. It’s a cold slap in the face when we’re getting cocky and complacent. It’s a reminder that the rational side of brains — not our reactive instincts — can and should run the show. Let’s all take a lesson from last week’s stock market volatility and keep in mind that the market isn’t the economy, which is improving. So I hope you kept your cool, bought stocks, and didn’t run for the hills.