The Weekly View (8/14/17)
What’s On Our Minds:
The war of words between President Trump and North Korea’s Kim Jun Un caused the CBOE Volatility Index (“the fear index”) to spike 55% last week. While volatility has been extremely low this year, last week’s spike serves as an important reminder that volatility will inevitably rear its ugly head every once in a while. Read on to learn what drives high volatility and how investors should respond when markets gets turbulent.
Originally used by chemists to describe chemicals that evaporate (and explode) easily, “volatile” has become the generic term for anything erratic or subject to sudden changes.
Today, most people hear about volatility in connection with investments and the stock market. But what does volatility mean in a market? Can we measure it? What does it mean for an investor’s current assets?
A Measure of Movement
Just like in chemistry, market volatility is about change. Stocks (or other investments) that are thought to have more predictable price fluctuations have “low volatility” while those expected to make drastic movements (both up and down) are said to have “high volatility.”
Most people use volatility to gauge the risk they are taking when purchasing an investment or planning a portfolio.
Highly volatile investments are judged as unpredictable with their returns. Though this means a volatile investment could significantly exceed its projected return, it also means that it is more likely to fall considerably short or cause a loss.
Two Types of Volatility
Investors commonly use one of two types of volatility when looking at stocks: historical volatility and implied volatility.
An investment’s historic volatility is measured according to its standard deviation—that is, comparing how much it has fluctuated in the past to its average rate of change.
Implied volatility, on the other hand, shows the expected volatility of a stock over the next 30 days. It is calculated using the current premiums on stock options.
Implied volatility is a measure of both anticipated performance and market sentiment. When option writers have increased concerns about a stock’s future price, they compensate by charging more for option contracts. The higher the premium they charge, the greater the anticipated fluctuations. The premium, therefore, implies the level of volatility.
The standard indicator of total market volatility is the Chicago Board Options Exchange Market Volatility Index—ticker symbol: VIX. It relates the implied volatility of all options on S&P 500 stocks due in the next 30 days.
Because the implied volatility is greatly influenced by investor emotions, the VIX is commonly referred to as “the fear index.”
What does High Volatility Mean for Investors?
Volatility is an inescapable part of investing. The future is uncertain and every investment carries risks.
However, unless an investor is involved with buying or selling options, a brief increase in volatility or the VIX is unlikely to require any changes to his or her investments.
A volatile market might cause stock prices to rise and fall by significant amounts, but it does not necessarily affect the future value of owning shares in a company.
Investors should choose stocks based on the underlying value of a company, not a temporary price fluctuation. The fear associated with the VIX should not give way to irrational buying or selling.
Nevertheless, prolonged periods of high volatility can make it more difficult for investors to plan for retirement. Even though the market could be rising in value, high volatility makes it difficult to set reliable retirement dates.
Those nearing retirement typically desire less volatility in their investments, as significant downturn can delay retirement by several years.
A high-volatility market is one that can produce both significant gains and significant losses. Investors must recognize that every investment has the potential to become volatile. Volatility is an expression of market fears and past changes, not a guarantee about the future.
Last Week’s Highlights:
Domestic markets have been on a strong run recently during a solid second quarter earnings season. 90% of the S&P 500’s companies have reported and 74% of them have beaten investor expectations. Last week, domestic stock indices experienced a bit of a hiccup due to geopolitical tensions surrounding the situation in North Korea. After a strong run, the Dow Jones broke its 10-day winning streak on Wednesday. The trash talk between President Trump and North Korea’s Kim Jung Un caused safe havens (bonds and gold) to rally last week. Overall, last week served as a reminder that investors can be an anxious bunch and that geopolitics can in fact influence our markets here at home. The team here at Tufton continues to remind our clients and friends that these types of short term market jitters should not weigh on your long-term investment objectives.
Aside from keeping an eye on the situation unfolding between the United States and North Korea, investors will continue monitoring earnings updates and continue trying to figure out what’s next for the Federal Reserve. The U.S Census Bureau will report retail sales for July on Tuesday. The Federal Open Market Committee will release its meeting minutes from its July 26th meeting on Wednesday and the first rounds of NAFTA negotiations between the U.S., Canada, and Mexico will commence. Weekly jobless claims will be released on Thursday. On Friday, we will close out the week with University of Michigan reporting their Consumer Sentiment figures for the month of August.