Volatility: what every investor should know

Amid continuous variations, sudden drops and sharp recoveries, market fluctuations can be unsettling for investors. Yet these movements are part of the normal functioning of markets. This is what we call volatility. Understanding this phenomenon and what it implies will help you better manage your investments and your emotions. myLIFE gives you a few insights.*

A few months ago, Malik decided to invest part of his savings in the stock market by buying shares. Since then, he regularly checks his portfolio to monitor the state of his investments. But this morning, he is worried: the value of his investments has dropped significantly in just a few days. Even though he knew this could happen, he does not really know how to react. Should he sell and accept the loss? Should he simply ignore the situation? Without being able to give a categorical answer, it is important for Malik not to worry and to recognise that these fluctuations represent a common phenomenon on the markets known as volatility. And to know how to deal with it, it is first important to fully understand what it is.

What is volatility?

In investment, volatility refers to the magnitude of variations in the value of an asset (share, bond, commodity, etc.) over a given period. One talks about volatility for a financial asset, but also for an investment portfolio, or even for an entire financial market.

The more the value changes significantly, either downwards or upwards, and the more this happens over a short period, the more the asset is considered volatile. Let’s take the example of two shares at €100. If the value of the first fluctuated between €80 and €120 in one month, it will be considered much more volatile than the second, which varied from €98 to €102 over the same period.

Volatility is a key indicator for assessing the risk of fluctuation of a financial investment.

Volatility is a key indicator for assessing the risk of fluctuation of a financial investment. When it is high, its future price is less predictable, since its value can vary greatly over a short period. High volatility therefore increases the risk of loss for an investor, but it also increases their prospects of return. Conversely, low volatility indicates that the value of an asset tends to be more stable and to evolve more gradually. Risks as well as profits are then more limited, but still real.

Thus, the level of volatility of a product is one of the criteria allowing investors to position themselves according to the risk they are willing to take and their return objectives. Cautious profiles, whose goal is primarily to protect their capital, will favour less volatile assets (government bonds, for example), while more aggressive ones, seeking to generate profit, will turn to investments presenting greater risks (such as shares).

What causes volatility?

Many factors can influence the volatility of an asset, a portfolio or a financial market. If a company reports turnover significantly below (or above) its forecasts or market expectations, this may cause its market value to fall (or rise). Similarly, a trade tension between two countries may generate concerns about economic growth prospects. This uncertainty may lead to volatility.

Among the most common causes are:

• • economic factors: variations in inflation, interest rates, growth expectations, decisions and communications from central banks, corporate financial results, decisions from executives, etc.
  • geopolitical factors: elections, government changes, political decisions, new regulations, international conflicts, trade tensions, etc.
  • psychological factors: investor sentiment, panic or euphoria movements, media amplification, etc.

Volatility is therefore the result of a set of economic, political or psychological elements that influence investor confidence and make market movements unpredictable.

There are two main measures to evaluate volatility: historical volatility and implied volatility.

How is volatility measured?

There are two main measures to evaluate volatility: historical volatility and implied volatility.

> Historical volatility (HV) analyses the past performance of an asset. This involves measuring the evolution of its price over a given period based on historical data. It evaluates how much the value of an asset has varied in the past. If, for example, a financial product has experienced strong price fluctuations over a short period, it will be said to have high historical volatility.

One way of determining HV is to calculate the standard deviation which assesses the differences in an asset’s returns compared to its average (daily, weekly, monthly, etc.). In other words, it indicates how much an asset’s returns deviate from their average.

> Implied volatility (IV) anticipates the future volatility of an asset based on the prices of options traded on financial markets. An option is a contract that gives an investor the possibility (but not the obligation) to buy or sell an asset at a pre-set price and on a specific date. Implied volatility thus reflects market expectations: if the market believes that the asset will remain stable, then implied volatility will be low.

The VIX index is based on the prices of S&P500 stock index options for the next 30 days and is frequently used to estimate future volatility of the index. It is nicknamed the “fear index” because it reflects investor concerns related to the companies included in the index.

Understanding how the market works is essential to objectively assess its variations. Investors can then make informed decisions, adapted to their profile and their financial strategy.

How does volatility impact investors?

When fluctuations are strong, the value of portfolios may rise or suddenly collapse. These periods will create uncertainty in the markets and will directly impact investors. In the event of a sharp drop, investors could then, under stress, make poor decisions and be tempted to sell their assets at the wrong time. Conversely, an unexpected rise could lead to reckless purchases.

Volatility also has positive aspects. A collapse in asset values may also be considered an opportunity to buy at low prices and a chance to obtain significant returns in the event of a market rebound.

Understanding how the market works is essential to objectively assess its variations, even if it means being helped by an expert in the field. Investors can then make informed decisions, adapted to their profile and their financial strategy.

How to manage volatility?

If volatility is inherent to the market, its intensity and evolution are difficult to predict. To help investors like Malik prepare for it and manage the associated risks, a few good practices exist.

> Diversify your investments: some asset classes are more volatile than others. To reduce the fluctuations in his portfolio, Malik would benefit from spreading his investments across different types of assets (shares, bonds, real estate, commodities, etc.) as well as varying geographical areas and sectors of activity. Potential losses from one investment can then be absorbed by the returns of another, which will improve the stability of his portfolio.

> Choose a coherent investment horizon: risky investments typically experience higher volatility than socalled “secure” investments and must be considered over the long term. In the event of a strong drop in asset values, losses may be offset over time if it was merely temporary turbulence.

> Invest progressively and regularly: rather than investing a large amount of money all at once, it is recommended to invest fixed amounts regularly, regardless of market conditions (high and low prices). This regularity will prevent Malik from buying or selling at the “wrong” time and will help him smooth risks by reducing the impact of sharp price variations. Of course, this means continuing to invest despite market volatility, not stubbornly investing in an asset whose fundamentals are continuously deteriorating.

> Keep an emergency savings buffer: it is never recommended to invest all your assets in the markets. Building emergency savings allows you to get through periods of uncertainty more calmly and will prevent our young man from having to sell his assets at a loss in case of temporary personal financial difficulties.

> Avoid hasty decisions: Malik should not lose sight of his initial strategy and should keep a cool head in the face of market oscillations, which are often cyclical. A sudden drop in the value of certain investments is often followed by a rebound. Managing to stay calm often prevents turning a potentially temporary loss of value into a permanent loss under the influence of emotion.

> Adjust strategically: the choices made must remain aligned with Malik’s financial objectives and his investor profile (cautious or more aggressive). As markets are dynamic, Malik is advised to periodically evaluate his investments and adjust them if necessary, to ensure they still meet his expectations. Again, assistance from an expert is highly recommended.

> Do not fall for the illusion of market timing. Rather than taking market volatility into account in their strategy, some investors attempt to predict future market movements to buy assets at the lowest price and sell them at the highest, exploiting shortterm fluctuations. Unfortunately, consistently anticipating peaks and troughs is extremely difficult, and this strategy implies high trading costs since it involves multiplying transactions excessively.

In any case, while no investment is riskfree and it is impossible to fully control the effects of volatility, combining these good practices can significantly help investors effectively manage market fluctuations.

Volatility is a normal phenomenon that is an integral part of financial markets.

Malik now understands that volatility is a normal phenomenon that is an integral part of financial markets. Understanding how it works allows him to better assess the risks of his investments, adapt his investment strategy and approach these fluctuations with greater peace of mind. He should not hesitate to consult his bank advisor or a competent expert in case of doubts or questions concerning his investments.

To conclude this article, let us recall as is customary that all investments carry a risk of capital loss and that past performance is no guarantee of future results.

* Content translated from French by the BIL GPT AI tool