What is Volatility?

What is volatility and how does it affect you? You may have heard of the word “volatility” during discussions of the stock market. Typically when there is a large jump or a large drop in the stock market, the news is quick to characterize it as “volatile”. The concept seems simple enough. However, is there something deeper to it? And, more importantly, can you make money from it?

In the most intuitive sense, volatility is a measure of risk. When the price of any good or service fluctuates rapidly, it is said to be volatile. On the surface, it describes that things are going up and down very fast and with very little predictive value. The informative value is tantamount to describing a red apple having the color “red”. However, there are deeper implications when prices fluctuate wildly without fundamental reason. We can start with the basics.

Lemons to Lemonade

Let’s say you want to make a lemonade stand. Lemons cost you $0.25 per lemon. Each lemon can make you 2 cups of lemonade sold for $1.00 each. If we say that the price of lemons is more or less constant throughout, you can expect to buy future lemons for a similar price. If you should expand your lemonade stand to a lemonade store, you can still expect to buy the lemons for $0.25 each (possibly less since you are buying at a greater volume). Your expected profit off of each lemon that you buy is $1.75 (2 cups of lemonade at $1.00 minus $0.25 cost of lemon. Water is free, yay!).

Let’s say lemon prices fluctuate wildly from $0.01 for 10 to $10.00 a piece. What does this mean for your lemonade stand? Well, if the price drops to $0.01 for 10, you make a lot of money. If it should rise to $10.00 a piece, you either lose money or make your customers very unhappy. Furthermore, if you were to buy lemons today for $0.25 a piece, and the price rose to $10.00 a lemon one day later, what should you sell your lemonade for? Would you sell it for $40.00 to match your competitors (to make the same percentage profit) or $1.00 to undercut your competitors? Whatever decision you make, it must make an assumption about future lemon prices.

For the Bigger Picture…

If you thought the lemonade stand was confusing enough, then imagine what things are like in the world of high finance. Stock market prices have been fluctuating wildly over the past few weeks. Although this is great for day traders and other risk takers, it doesn’t bode well for the grand perspective of the economy. So much uncertainty inhibits investments and expansions. If you don’t believe me, ask a simple question. Would you invest money in the stock market if it went up and down 50% a day without warning or reason? Would you open a new restaurant when food prices are wildly fluctuating?

There is also another point of clarification. Volatility is not simply the magnitude of prices changing. If the stock market were to rise 10% a day for the next month, “volatile” would be an incorrect label for it. The reason is because with a guaranteed and predictable 10% a day for the next month, there can still be some business planning. The flipside is true as well. If the market fell 10% a day for the next month, there could still be “some” business planning. However, the problem with the markets isn’t the volatility, but something else entirely. In short, next time you hear the term “volatile”, be cautious to realize that it indicates both large and unpredictable change in prices.

Protecting Your Money

So how do you protect yourself from volatile markets? Keep in mind that short term volatility may rattle a few cages and create some more worry lines on your brow but it is ultimately a fleeting monster. Long-term volatility signals insecurity in a financial system or government. If this does exist, then there are far greater things to worry about than lemonade stands and falling markets. It is probably why people are so anxious about short-term volatility because if it is prolonged, it may be an indicator of something worse to come.

If you are interested, you can look into a concept called “hedging”. Hedging is a financial strategy that limits your losses at the expense of limiting your profit. It would allow those more risk averse to enter into volatile markets without needing to vomit. It’s not a 100% answer, but it is certainly a tool to consider if investing is the direction you wish to go.

-Wishing you a safe investment, EC

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