Following the COVID-19 pandemic, the war in Ukraine, and associated economic stresses, we’ve all read a lot recently about market volatility. But what does it mean in practice?
Market volatility really refers to rapid changes in the market index—the larger and quicker the fluctuation in the value of stocks, the more volatile the market is. Generally speaking, high rates of volatility are associated with periods of economic decline or recession, whereas lower volatility is a sign of (or prerequisite for) economic growth. However, market volatility can, in fact, cause an individual portfolio to decrease or increase in value, so it’s not necessarily a disaster for investors. However, the biggest problem is that a volatile market is an unpredictable one—and investors like predictability.
Sectors Prone to Volatility
Given this unpredictability and the potential for large losses, one might think investors would avoid the most volatile sectors. Unfortunately, volatility can affect all sectors at some point, including some of the most popular with investors.
In the current economic climate, it probably comes as no surprise to learn that energy is the single most volatile sector. Oil and gas prices can fluctuate wildly due to supply and demand, which are dramatically affected by conflict and international relations. This also has a knock-on effect on renewable energy prices.
Commodities come a close second in terms of volatility. This sector covers a wide range of physical goods from precious metals like gold (traditionally stable) to building materials and foodstuffs (which can be affected by environmental issues as well as politics).
The finance sector itself—including banks, financial and insurance services, brokerage firms and more—is also prone to volatility and can be affected by myriad forces. Technology, a sector which covers the ubiquitous electronic goods like televisions, computers and mobile phones, is another volatile sector, partly due to the rapid developments in the field.
Rounding out the top eight most volatile sectors are consumer goods (retail, media, and consumer services), communication services (telephone and internet providers, etc.), healthcare (including hospitals, health firms, medical goods and pharmaceuticals), and utilities (covering water, electricity, and other civil infrastructure).
What Causes Market Volatility?
The above suggests that it is those sectors that are truly international in scope (i.e., energy and finance) that are most prone to volatility, whereas sectors that are more nationally or regionally focused (e.g., utilities and healthcare) are less so. Indeed, in our increasingly interconnected world, markets can be affected by global (or national) economic, political, or even environmental factors.
Political influences might include wars, revolutions, or political unrest. Economic impacts can come from industrial action, recessions, or financial turmoil. Meanwhile, Environmental factors include famines, drought, floods or wildfires. Sometimes we are able to see these events coming—a poor harvest inevitably following a period of drought, for instance—whereas at times they are random and unpredictable—for example, when the Ever Given became trapped in the Suez Canal, affecting supply chains worldwide!
Fundamentally, though, market volatility is a reflection of the way investors feel about their investments at given moments, and therefore the markets can sometimes become volatile with no obvious external cause.
Volatility can be driven by emotion, with fear and panic setting in amongst traders and causing a chain reaction. Noise trader risk refers to a trend where inexperienced traders succumb to their emotions: Uncertain markets cause investors to become nervous and make rash decisions, and then the markets themselves become ‘jittery’, affecting even the most experienced. Major news events—either positive or negative—can cause very large swings in stock prices, as can big lot sales, for example.
It is worth mentioning that the financial markets themselves can play a huge role in influencing market volatility. For instance, changes in one market can cause volatility in another. Markets are also affected by interest rate hikes, and monetary policy imposed by the Federal Government. Of course, the Fed can also help in times of high volatility, by introducing trading curbs, which freeze trading for between 15 minutes to an entire day.
Dealing with Volatile Markets
Market volatility is inevitable, the key is knowing how to deal with it. The approach is different from the point of view of either a business, or an individual investor:
First, make sound financial decisions. Businesses need to forecast the potential financial implications of any wild fluctuations in prices. They also need to hedge against possible volatility, spreading a portfolio and hedging future options or contracts.
Second, improve commercial efficiencies and mitigate potential losses. Initially, this means cutting any unnecessary expenses—simple things, for example, like reducing costs by buying in bulk, where relevant. Other important steps to take include locking in rates with suppliers—this will depend on a good working relationship. Importantly, don’t feel the need to absorb any increases in costs. Instead, ensure that your customers understand what’s happening and explain that costs may temporarily increase—the odds are that they will understand, especially if there is a global cause like a war or financial crisis.
One more interesting factor that businesses can consider is to adopt blockchain-based solutions. These hold real potential in terms of addressing inefficiencies, helping to manage customer relationships, supply chains, transaction auditing, and reducing fees associated with credit cards.
As far as individuals are concerned, it’s really all about making contingency plans for volatility, mitigating any losses, and weathering the storm. During periods of volatility, it can seem counterintuitive to invest further, but continuing to make regular investments is key, and your portfolio will thank you in the long run. It’s also definitely worth looking into tax-loss harvesting, which is a strategy that enables investors to offset investment losses against any gains to lower tax liability. As far as retirees are concerned it’s important to maintain a reserve in cash investments, ideally an equivalent of a year’s worth of anticipated withdrawals.
Remember, over time, stock typically has an upward trajectory. Any deviation to that expected movement is down to volatility, so try not to panic in times of market turbulence. Understandably, savvy investors will want to choose stable or predictable markets, those which have the least volatility. But as volatility is possible in any sector, it’s important to understand it and be prepared.