Volatile Swings Of Fortunes
Which stock index is the most volatile one? In the following article, Armaan Madhani takes into account the nature and effect of volatility and points out why volatility is an investor’s friend
Volatility is one of the most common industry-specific jargons, perennially used in the stock markets. Stock market and volatility go hand in hand. Despite having heard the term volatility frequently, majority of us fail to understand its precise meaning. Volatility is the rate at which the price of a financial security or index increases or decreases over a particular period of time for a given set of returns. It is a statistical measure generally measured as either the standard deviation or variance between returns of the same security.
If a company’s share price fluctuates rapidly with big erratic swings in either direction, it is termed to have high volatility. Conversely, if the share price is stable and moves in a relatively narrow range, it is said to have low volatility. In majority of the cases, the higher the volatility, the riskier the security as the price is expected to be less predictable. Stock market volatility in many instances is driven by economic and political factors, government policies, industry or sector-specific factors, company performance and news. Historical volatility represents the degree of variability in the returns of a security and is based on historical prices.
However, volatility is an investor’s friend. It helps to gauge the fluctuations in markets that may transpire in the future. To quote eminent American author and investment advisor John Train, “For the investor who knows what he is doing, volatility creates opportunity.” For investors who have a firm belief in the stock market’s potential to generate healthy returns in the long run, downward market volatility furnishes a chance to invest in securities at lower prices and attractive valuations. Similarly, investors can take advantage of upward market volatility to book partial or complete profits and invest the proceeds in other assets that present greater opportunity.
Understanding Market Index
A market index is a hypothetical portfolio of security holdings that represents a specific segment of the stock market. Any change in prices of underlying securities directly impacts the overall value of the index. The security selection criteria for the index could be based on various factors such as market capitalisation, industry, sector size, profitability and liquidity. The index weighting scheme which determines the amount of weight each constituent security should be assigned can be based on price, market capitalisation or even fundamentals. Indian domestic indices Nifty 50 and S & P BSE Sensex are calculated using the free-float market capitalisation-weighted method.
An index is a statistical measure that distinctly reflects fluctuations happening in the financial market. Stock indices often serve as benchmarks for giving a picture of the economy in general and the markets in particular. Movement in the index forms a broader picture that helps investors compare the current price levels with past prices to evaluate market performance. Global indices work as benchmarks to evaluate the state of a particular nation’s overall capital market as well as a barometer of economy robustness. Despite varying methodologies of constructing global indices, most of them are based on market capitalisation and free float weighting.
A global index is commonly used as a proxy for passive portfolio investments by multitudes of domestic and foreign investors in the form of index funds or exchange traded funds (ETFs). Typically, stock market indices are assessed on the basis of two key parameters – returns and risk. The ideal mechanism to evaluate the riskiness of an index is variance or standard deviation, which is used to estimate volatility. One must keep in mind that volatility tends to work both ways. Low volatility tends to make the index safer on the risk scale, however simultaneously it also proportionately reduces profit-making opportunities. The following table stipulates the volatility in 2021 of major global indices on a regional basis.
The Dow Jones is typically the least volatile of the three headline US indices as majority of its components are slower moving, venerable blue-chip companies such as United Health, Goldman Sachs, Honeywell International, Visa, American Express and 3M. The Nasdaq 100 index represents the largest non-financial companies listed on the Nasdaq exchange and the technology sector accounts for approximately 54 per cent of the index’s weight. Therefore, it is regarded as a technology heavy index. It is the most volatile of the three prominent US stock market frontline indices because of its high concentration in relatively riskier, high-growth technology companies such as Facebook, Amazon, Alphabet (i.e. Google) and Microsoft.
The Pandemic Effect
The global pandemic caused all stock market indices around the world to fall sharply in March 2020. However, the extent of the decline and the shape of subsequent recovery have been significantly motley and varied. For example, on March 15, 2020, the US frontline indices Dow Jones and S & P 500 along with major European markets shed around 40 per cent from their highs on January 5, 2020. However, the technology-dominated Nasdaq 100 index and several Asian markets lost only 20-25 per cent of their value. A similar story is observable during the post-corona virus recovery phase.
As of July 18, 2021 the Nasdaq 100 was around 55 per cent higher than in January 2020, while most other markets were only between 10-33 per cent higher. The notable exception to this is the UK’s FTSE 100 index and Hong Kong’s Hang Seng index, neither of which have surpassed their early 2020 values. If a security has a 30-day volatility of 67 per cent, it means that if the stock continued to move as it has for the past 30 days, it would likely experience a total price change of 67 per cent either up or down over the next year.
According to data compiled by ET Intelligence Group from Bloomberg, the 30-day historical volatility of the equity benchmarks of the US, UK, Germany, France, Brazil, and India increased 5-17 times in March 2020 since the reporting of the virus outbreak in January 2020. To quote an excerpt from an article in Economic Times, “The 30-day volatility of the MSCI World index rose to 58.7 per cent from 5.3 per cent and that of Dow Jones increased to 75.9 per cent from 7.5 per cent. The volatility of the NSE Nifty 50 increased four-fold to 44 per cent.” Let’s juxtapose the US Dow Jones Industrial Average index and India’s S & P BSE Sensex index. Both are large-cap indices comprising 30 stocks each.
In terms of valuations, the Dow Jones index has a price to earnings (PE) ratio of about 22 whereas the PE ratio for Sensex stands at about 31. This doesn’t mean that the Indian stock markets are relatively overvalued than the US markets. It simply means that the market participants believe that earnings of Indian companies will grow faster than US companies in the coming years. However, in comparison to the Indian markets, the US markets have been less volatile in the long run. Indian equities have shown great volatility, with bigger swings in returns over the years.
Conclusion
In 1994, renowned investor and author Peter Lynch was asked at a forum whether he was concerned about the level of volatility in the US’ equity markets during his speech. He responded by saying, “I love volatility. I think volatility is terrific.” He then went on with his views: “Human nature hasn’t changed a lot in 25,000 years, and some event will come out of left field and the market will go down or the market will go up. So volatility will occur and markets will continue to have these ups and downs. I think that’s a great opportunity if people can understand what they own.” Market volatility is inevitable; it’s the nature of the stock markets or indices to move up and down over a period of time. However, investors should be aware of the potential risks during times of high volatility and their own risk appetite. Trying to time the market is out of the question. A simple yet effective solution is for investors to ignore the short-term fluctuations and maintain a long-term horizon.