Volatility is a measure of how intensely an asset's price swings. If a stock's price varies unpredictably and by a considerable amount, then that stock is typically considered volatile.
Naturally, volatile assets tend to be perceived as riskier than less volatile assets because their price is expected to be less predictable. Let's go over the concept of volatility, some examples and how it can affect your portfolio.
Before we get into how volatility relates to your investments, though, let’s quickly go over the concept of volatility itself.
“While variance captures the dispersion of returns around the mean of an asset in general, volatility is a measure of that variance bounded by a specific period of time” - Source: Investopedia
Volatility can be measured according to different time-frames (on a daily, weekly, or monthly basis, for example). The annualized standard deviation of an asset's price is a useful way to think of volatility, though, since it can help provide an idea of an asset’s standard deviation over time - otherwise known as historical volatility.
There are also interesting indicators of systemic volatility, such as the CBOE Volatility Index (VIX) created by the Chicago Board Options Exchange. The VIX is a real-time, widely used index that represents the market's expectation of 30-day future volatility.
Since it provides a measure of investors' sentiments regarding risk, the VIX is also called "the fear index". When the VIX is at high levels, that usually means that investors are expecting a market downturn.
“The VIX rises as a result of increased demand for puts but also swells because the put options' demand increase will cause the implied volatility to rise. Like any time of scarcity for any product, the price will move higher because demand drastically outpaces supply” - Source: Investopedia
As an investor, you may take volatility into consideration when assessing the risk of your investment. Have in mind, though, that volatility may not be all bad. Despite increasing the potential for loss, volatility also increases the potential returns on your investment.
Day traders, for instance, seek to profit from volatility that occurs minute-to-minute, while swing traders focus on slightly longer time frames, usually days or weeks. Whether you should invest in a volatile asset or not depends on many factors, including your risk tolerance and the time horizon of your investment.
There are also investors who just don’t care much about volatility. Long-term value investors who "buy and hold", for example, generally aren't phased by moderate market fluctuations, since they don't intend to liquidate their investments too soon. Instead, they prioritize indicators such as intrinsic value over volatility or trading volume.
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