Decoding the Stock Market: The Vocabulary of Volatility

Here are some of the most important volatility concepts for investors to know.

When the stock market is making large up and down moves on a regular basis, you may hear that we're in a "volatile" market, but what does that mean?

While the word volatility is often used to describe general stock market action, or big movements in a certain stock, there's quite a bit more to the concept of volatility than that. So, here's a look at what volatility really means, as well as the most important volatility-related information investors should know.

What is volatility?

A more specific definition of the word volatility when it comes to the stock market is how large the price movements of a stock or index have been (or are expected to be). Without turning this into too much of a statistics lesson, the key point to know is that volatility is a measurement of the standard deviation of returns from a stock index or individual security.

Many investors associate volatility with stock market crashes and corrections, and for good reason. When the market is falling, large moves are certainly more common. In other words, stocks occasionally crash to the downside, but they seldom "crash" upward. For most of the past five or so years, stock market swings of 1% or more in either direction weren't terribly common. But in March 2020, when the coronavirus outbreak hit, moves of 5% or more became the norm for a while.

Having said that, while volatility usually picks up when the market crashes, it's important to realize that volatility can go in both directions. For example, if you hear that a stock is "more volatile than the overall market," it doesn't necessarily mean the stock is more likely to fall. It just means you should expect larger price swings.

In a nutshell, think of volatility as the uncertainty involved with investing. If the S&P 500 is volatile, it means there's a wide range of potential returns. If a stock is volatile, it means the short-term price movements of the stock are likely to be more dramatic than a stock of average volatility.

While there are many different methods analysts use to calculate and assess volatility, there are two main types of volatility metrics: historic volatility and implied volatility. Historic volatility calculations involve analyzing a stock's (or index's) previous price action, while implied volatility is a metric that shows how volatile investors expect a security or index to be going forward.

With that in mind, here are the two most important volatility metrics for investors to know.

Beta can tell you how volatile a stock usually is

If you look at a long-form stock quote through your brokerage, or through a financial news outlet, there's probably a metric known as beta listed somewhere in the quote information. Beta is a measurement of a stock's historic volatility compared to the S&P 500 index.

A beta of more than one indicates that a stock has historically moved more than the S&P 500. For example, a stock with a beta of 1.2 could be expected to rise by 1.2% on average if the S&P rises by 1%. On the other hand, a beta of less than one implies a stock that is less reactive to overall market moves. And finally, a negative beta (which is quite rare) tells investors that a stock tends to move in the opposite direction of the S&P 500.

The VIX gives you a current snapshot of the market's volatility

The CBOE Volatility Index, also known as the "volatility index," or simply "the VIX," is a measurement of the expected volatility in the market over the next 30 days.

The number itself isn't terribly important to understand, and the actual calculation of the VIX is quite complex. What is important for investors to know is that the VIX is often referred to as the market's "fear gauge," meaning that if the VIX rises significantly, investors could be worried about massive stock price movements in the days and weeks ahead. My colleague Dan Caplinger recently wrote an excellent discussion of the VIX and what it means if you're interested in learning more.

Why is knowing volatility important?

To be clear, this isn't an exhaustive discussion of all of the volatility terms that exist in the investing world, but they are the most important volatility-related concepts for everyday (non-professional) investors to know and understand.

By understanding how volatility works, you can put yourself in a better position to understand the current stock market conditions as a whole, analyze the risk involved with any particular security, and construct a stock portfolio that is a great fit for your growth objectives and risk tolerance.