By way of definition, volatility means instability; potential danger; unpredictable in nature; and fickle. In regards to investing, volatility is simply explained as — the amount by which stock prices vary from the mean, or average, value over time .
On Wall Street, volatility is a term used to describe how much the price of a security moves up and down. When the price moves up or down rapidly, volatility is high. But if the price is very stable, or moves up or down slowly and methodically, volatility is low. The good news is that you don’t need to know how to calculate a stock’s volatility in order to use it to your advantage while investing. Nevertheless, it is a good idea to know what it is and how it is measured.
According to market research studies, the more volatile the market, the higher the chances that prices will fall. For example, one study shows that the probability that the S&P 500 Index will rise in price during any particular month in which volatility is low — between 0% and 1.1% of the index’s average daily range — is 68%.
However, chances soar to 58% that the benchmark index will decline when volatility increases between 1.8% to 4.2%. 1 As you can see, increasing volatility means a higher chance the market will decline… yet, professional investors and money managers embrace volatility because most feel it presents opportunities that couldn’t otherwise be seen during periods of low volatility.
Here’s why understanding volatility is important: History shows that years characterized by low volatility are typically followed by increasing volatility within six to twelve months. Since 2004 was a low volatility year, we expect volatility to increase in 2005 – 2006. That’s why it is critical that you understand volatility and recognize that as professional money managers, we are already taking action to reduce risk and grab beneficial opportunities from it.