The volatility of a stock or asset is the change in value within a specific period of time. If the value of an asset fluctuates frequently, it is considered very volatile. Asset price volatility is almost unavoidable and even desirable in that it shows the asset's response to events and future prospects in the micro and macro environment. When market conditions change due to political movements or macroeconomic shocks, the asset's volatility alerts the buyer and almost warns them of future shocks.
Asset price volatility can lead to financial instability and is therefore a concern for investors and analysts. They allocate financial resources based on expectations of financial market behavior/returns and respond to different underlying conditions. Market volatility can be determined by the standard deviation of price changes over a given period of time. The standard deviation value can allow you to see the deviation of prices from the mean.
Reasons for volatility
1. Low volatility: Good stock performance can lead to a long period of low volatility. Lower correlation between different sectoral stock indices could also contribute to lower volatility. According to value-at-risk (VaR) metrics used by risk management experts, low volatility in financial markets reduces expected loss over a given period and can stimulate risk taking. Low volatility can also encourage building leverage.
Investors can become overly complacent during periods of low volatility, believing their portfolios are sufficiently diversified. It can lead to further risk-taking. Additionally, there could potentially be significant losses if there is a sudden increase in volatility.
2. Unfavorable macroeconomic environment: A deterioration in growth prospects could have a negative impact on companies' profit prospects and drag down share prices. This, in turn, could lead to further market volatility as investors could become skeptical about future cash flows. The phenomenon was apparently observed in the United States during the Great Depression in the 1930s. Stock markets then became excessively volatile and remained so for an extended period of time.
3. Low interest rate environment: In a low interest rate environment, investors have an incentive to add to their portfolios at lower interest costs, resulting in unexpectedly large losses when volatility occurs and subsequently impacts different asset classes. Market insights show that low volatility equity strategies have gained popularity following the global financial crisis. In a low interest rate environment, these strategies have generally performed strongly. However, they are particularly vulnerable to changes in market conditions. When the Federal Reserve raised interest rates by 500 basis points in FY23, it triggered a ruckus in the stock market as leveraged trades were unwound, triggering a domino effect on other asset classes.
4.Stock return correlation: Empirical evidence suggests that rises and falls in the stock market reduce and increase the volatility of financial assets, respectively. One possible interpretation links the inverse correlation to changes in risk perception, as lower volatility is associated with greater risk-taking, while a period of low volatility likely coincides with an upward trend in asset valuations.
Lessons for market participants
It is essential that policymakers and market participants learn lessons from past episodes of volatility to control factors such as debt, lack of liquidity and lack of transparency and prevent volatility from turning into instability. It is an ongoing process and each crisis and resulting market innovation can help policymakers improve their understanding.
Investors must have sufficient buffers to withstand higher market volatility and possible negative impacts such as falling financial asset prices and widening credit spreads. Investors would do well to keep the following in mind:
· Investing is a long-term game. Regardless of whether the market is volatile or stable, it is advisable to buy stocks with excellent fundamentals. In the long term, their returns will exceed inflation.
· Refrain from panic selling as seen during the Covid-19 pandemic when stock markets worldwide, including in India, fell about 30%. Markets subsequently recovered and reached new highs, highlighting the value of patience.
· Highly volatile markets often provide an opportunity to buy great stocks at discounted prices. Create an emergency fund to provide liquidity for such bargain purchases.
In volatile times, the best strategy is to remain calm and patient and wait for the storm to pass. Good companies will weather adverse situations and ultimately survive turbulent times while generating returns above and beyond inflation, as has been seen recently. If you remain calm and disciplined as an investor, you can make the most of volatile markets.
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