Since the financial crisis of 2008, many have become afraid of the stock market. The volatility on the stock market, with three-digit gains one day and three-digit losses three days later, has created fear of investing in the market, especially for those with retirement accounts. However, it is important to remember that the stock market has always been volatile (although to varying degrees throughout the years). Without volatility the chance for profits would be much smaller. And, besides, even with the volatility in the stock market, over time the market comes out ahead — or at least it has historically. There has yet to be a 25-year period that saw losses for the overall market. While there is a first time for everything, a scenario in which the market loses over such a long period is unlikely.
How is Stock Market Volatility Index Measured?
Stock market volatility is actually measured regularly. The Chicago Board of Options Exchange uses the Volatility Index (VIX) to express stock market volatility. Throughout the day, every 60 seconds, the VIX takes a weighted average of eight stocks on the S&P 100. In addition to using the VIX, a similar method is also used to measure technology using the Nasdaq Volatility Index (VXN). These measures can help provide an estimate of the volatility seen in the market. However, these measures don’t actually provide insight as to the causes of stock market volatility.
Perception: Perhaps the Biggest Factor in Stock Market Volatility
We often think of “the market” as something that is influenced by factors such as how the economy is doing and whether profits are rising or falling. These items do influence the stock market, but, by themselves, do not actually influence markets very much. In reality, it is more likely to be reactions to news about the economy that affects the market. Stock market volatility is largely a matter of perception. Motivated by fear or greed, investors change their positions based on what they think might happen. Many wonder if this defines what is investing.
Because emotions can change from day to day, short-term stock market volatility is quite prevalent. However, if you look at stock market performance in wider time frames, it starts to smooth out somewhat, and volatility isn’t nearly so obvious. The 500 point drop of one day on the Dow disappears into the overall trend that shows that, over 30 years, the Dow overall might have gained more than 2,000 points.
Another consideration is that often “the stock market” is perceived as the Dow Jones Industrial Average. Many people found their fears and hopes — and their subsequent decisions — on an average of 30 companies. The Dow represents only a very small fraction of the total stock market, but our perception of it contributes to stock market volatility.
Dealing with Stock Market Volatility
Your reaction to stock market volatility can make a big difference in the size of your nest egg down the road. If you are constantly following the herd, you will miss out on chances to grow your wealth, and the fees associated with transactions made with each change in the market will start to add up. Instead, make a long-term investing plan, and then do your best to stick with it.
One of the best ways to overcome stock market volatility is to consider dollar cost averaging. If you stick with investing the same amount over time, you can take advantage of downturns in the market, buying more for less — something that will help you when the market eventually recovers. You will have more shares that you can sell for a higher price. You can also consider index funds that track whole indices, rather than dealing with greater volatility and uncertainty that is often seen in individual equities. You can also diversify your portfolio to include cash and bonds.
In the end, basing your long-term investment decisions on the panic — or manic — of the current moment can be detrimental. Over time, stock market volatility usually smooths out. If you can make a levelheaded plan and stick to it, you are more likely to see success in your portfolio.
Try Morningstar to Review Your Portfolio
Many investors are clueless on what they really have in their investment portfolios. What that also means is that they have no idea how their investments have performed, how high the expense ratio is, or how it’s compared to others like it. A quick and easy solution to get a true snapshot of what your mutual fund portfolio looks like is to use a tool like Morningstar. Morningstar is like the Consumer Reports of the mutual fund industry, just providing the clear cut facts on how the fund is really doing. Reviewing your portfolio could help big in helping with the volatility in the market.