In chemistry, ‘volatility’ refers to the ability of a substance to evaporate quickly—or, under the right conditions, to explode. In investments, it means much the same thing.
Volatile investments appeal to many investors, because they see volatility as their source of profit—what can go down far and fast can also rise that way. You might say these investors confuse volatility with risk. But the two can differ.
Risk has to do with your chances of being right or wrong—whether companies you own shares in will prosper or go broke. Volatility has more to do with the consequences of being right or wrong, and on how long it takes to find out. A promotional stock with little in the way of assets or profit prospects can display low volatility for lengthy periods when the promoter is in control of the market. But it still exposes you to great risk.
From time to time, on the other hand, high-quality stocks become volatile—due to fast-changing regulatory or business developments, say. Recent gyrations in bank stocks are a good example; they became more volatile in the spring because of the impact of the coronavirus on the economy. But because of their high investment quality—their substantial assets, solid business bases and so on—they still expose you to low risk of substantial long-term loss.
Aggressive versus defensive stocks
It’s also easy but mistaken to see volatility as the key difference between aggressive and defensive investments. Aggressive investments do tend to be more volatile, of course. But these two kinds of investments lie at either end of a continuum, and volatility is just one of many factors that vary between the two ends of that continuum. Other factors that also change from one end of the continuum to the other are the degree of stability in the business, length of dividend history, hidden assets on the balance sheet and so on.
Volatility is a relative term—it always involves comparisons. Over the years, a number of analysts have tried to quantify volatility. Best known of these is the ‘beta co-efficient’. If a stock moves in line with the markets (or some segment of it), it has a beta of 1.0. A beta above 1.0 means greater volatility, and a beta below 1.0 means less volatility—more stability you might say.
Lots of factors can raise or lower a stock’s volatility. Few would surprise you. Volatility depends partly on the type of business a company is in. Companies in the manufacturing and resource sectors of the economy generally show above-average volatility; companies in the utility and financial sectors show below-average volatility. Regardless of sector, the shares of a company that is undergoing a restructuring are almost certain to be more volatile than those of a company in a settled phase of operation.
High overhead, heavy capital expenditures, large debt or changes in the market can also expand a stock’s volatility. Examples abound—Air Canada, Magna International, Restaurant Brands International, Russel Metals and so on.
Watch out for thin traders
Thin trading shares are generally more volatile than liquid, active traders, because it takes a smaller buy or sell order to move prices. For the same reason, low-priced stocks are often more volatile too. Low-priced stocks also attract traders.
If you invest in volatile stocks, you should plan to monitor your selections carefully. In volatile stocks, after all, matters can deteriorate quickly. You need to pay close attention if you hope to figure out when to sell profitably, or to cut your losses.
Don’t avoid volatility altogether
Mind you, you should avoid the temptation to stay out of volatile stocks altogether. Some investors buy a portfolio of stable stocks, then become supremely detached to their investment performance. But it’s by no means unknown for a respectable, placid stock to lose ground gradually—almost imperceptibly—over a period of years.
Above all, keep in mind that a volatile stock is ordinarily volatile for one key reason: nobody knows what it really is or should be worth. To put it another way, nobody knows how things will turn out for it. But they do think the outcome could differ drastically from the status quo.
This is an edited version of an article that was originally published for subscribers in the August 7, 2020, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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