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Understanding Market Volatility to maximize returns: Demystifying investment ShiftAltCap Series

Updated: Dec 16, 2022

Welcome to our Demystifying Investment series, which aims to simplify investment must-know terms essential to making investment decisions. We hope you have familiarized yourself with the last part that dejargonized the Sharpe ratio.[1] In this part, we will shed light on market volatility and investments strategies to tide over extremely volatile markets.

Understanding Market Volatility

“Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.” - Warren Buffett

A stock’s volatility is a measure of its tendency to go up or down within a timeframe. It is the spontaneous increase or decrease in its value measured mathematically as its ‘standard deviation’ from the average or expected value and represented by the symbol "σ. “ The higher the price change in any direction, the higher is its volatility.

However, higher volatility does not imply higher risk. Risk is the possibility of losing money without any gains, while volatility is the possibility of losing money or making a profit.

Consider two stocks, X and Y; if the price of stock X varied between +8% to -10% and that of stock Y varied from +5% to -5% in the same year, stock X was more volatile than stock Y. Simply put, higher market volatility means you can potentially make a higher than expected profit or run the risk of making a larger than expected loss.

What Causes Market Volatility?

The most common and obvious reasons that cause volatility in stocks and indexes include:

Investor Sentimentality

The sociopolitical sentiments of investors drive them to buy or sell in markets and create unfathomable volatility.

Critical Events

Stocks or markets are always found to be moderately or even significantly volatile around the time of crucial events, such as personnel changes, controversial financial news, changing expert opinions, announcements of mergers, buyouts, or initial public offering (IPO), etc.

Ease Of Trading

One current factor that has declined market stability is the increased participation in the markets due to easy access to real-time trading accounts, market news, and forums through apps and social media. What amateur online traders were able to do with the GameStop stock last year is the best example in this aspect.

Social Catastrophes

A national or global-level issue always spooks investors into revamping their portfolios across sectors. The COVID-19 pandemic caused similar turmoil, and the hospitality stocks took a major hit. Back in 2008, the banking market suffered from similar losses for a long time due to investor skepticism.

Calculating Volatility