Volatility

The value of the stock market goes up and down, meaning that those invested in stocks and funds gain and lose money over time without taking any action. This movement is a feature, not a bug — the stock market is designed to continuously shift and change.

This up-and-down fluctuation in the value of the market, and of individual stocks and funds within the market, is called volatility.

What Is Volatility?

Volatility is a measure of how much the price of a stock or the value of the market changes over a specific period. That is to say, it’s an indication of how big, erratic, and rapid the up-and-down swings are.

The statistical measure typically used to assess volatility is standard deviation, which indicates how far the highs and lows stray from the average price. A stock or fund whose value is cratering and/or skyrocketing is very volatile, while one that shifts only a little does not have much volatility.

Volatility is a term that has negative connotations; many people use it to indicate a downward swing or crash in the market. However, volatility makes no judgement. The concept also includes upswings, which can help investors make money.

The idea to take away is that the greater the volatility, the riskier the investment. More than anything, volatility is an indication of short-term uncertainty.

How To Assess Volatility

You can assess the volatility of an individual stock or fund by looking at a metric called beta, which measures its historical volatility in relation to the S&P 500 index. If the beta is greater than one, the stock or fund has historically been more volatile than the S&P 500. A beta less than one indicates that the stock or fund has historically been more stable than the S&P 500. And a negative beta — an unusual occurrence — shows that the stock or fund has typically moved opposite the S&P 500.

You can assess the market as a whole by looking at the Chicago Board Options Exchange Volatility Index (VIX), which measures how much volatility is expected in the market in the next 30 days. The specific number the VIX lands on doesn’t really matter; its movement is more significant — if the VIX jumps upward, that usually means that a lot of volatility is on the way. This is why its other names are “Fear Gauge” and “Fear Index.”

Implied Volatility vs. Historical Volatility

Traders might look at two different types of volatility when judging what is likely to happen. Implied (or projected) volatility is a prediction of how volatile the market will be over a certain period. This metric is calculated using the prices of options. Since this is a prediction, it isn’t set in stone; the market may move differently than an assessment of implied volatility suggests it will.

Historical (or statistical or realized) volatility is a measure of how volatile a stock has been in the past during a particular period. It usually measures volatility by looking at the change in the closing price from one date to another, usually 10 to 180 trading days apart.

How Much Market Volatility Is Normal?

It is common and expected for markets to be volatile on a regular basis. During any given year, investors typically expect returns to deviate some 15% from average. Periodically — say once every five years — you’re likely to face more volatility, perhaps around 30%.

The amount of volatility that’s normal in a market is related to the general trend of the market at that time. The market can be either “bullish” (trending upward) or “bearish” (trending downward). Bullish markets are typically fairly stable, while bearish markets often have high volatility, with unpredictable swings that end up moving the market downward.

How to Handle Market Volatility

To be a savvy investor, you must learn to be comfortable with volatility. A cardinal rule of investing is to resist selling a stock or fund as soon as the price plunges. In fact, that old saying “buy low, sell high” should be your guiding principle — when the price takes a hit, it’s a better time to invest than to sell.

Historically when the market falls a lot, it comes back stronger — generating large gains once it recovers. Knowing this can help you avoid the mistake of selling when you shouldn’t. Also keep the following advice in mind:

• Stick to a long-term plan: If you need the funds you’re investing in the near term, then you shouldn’t be in the market in the first place. The stock market is best left to those who can let their money weather the volatility and see eventual gains over years of investing.
• Buy low: Purchasing stocks and funds that have had a strong track record during downturns is like buying good products at a discount. If you do so with the long term in mind, you may well eventually see a large return from the decision.
• Keep some liquidity in your finances: You can remain sanguine about market volatility if you don’t need to pull your money out right away. You should have enough cash on hand in an emergency fund or other savings account so that you can safely leave your portfolio alone, even when prices are dipping downwards.
• Rebalance your portfolio: Since volatility can result in changes to the relative values of the investments in your portfolio, it’s a good idea to rebalance periodically to make sure your asset allocation remains where you want it.
• Get out of the market if you’re about to retire: Investors who are close to retirement will find too much risk in the naturally volatile stock market. They should put up to two years’ living expenses in non-market assets such as bonds, cash, home equity lines of credit, and cash values in life insurance.

How ETFs and Mutual Funds Can Protect You Against Volatility

One way to volatility-proof your investments is to choose some well-diversified ETFs or mutual funds, which can offer some downside protection and reduce your risk. Since these funds bundle multiple stocks — sometimes as many as 1,000 — they are likely to be somewhat insulated from the risk presented by volatility.

While both ETFs and mutual funds can help diversify your portfolio and reduce your risk, ETFs may be a better option for responding to volatility because of the speed of transaction they enable. It can take several days to make changes to a traditional mutual fund, while ETFs are traded like stocks and can transact much more quickly. This means you can take advantage of dips in the market by quickly investing more in your ETFs, or, if you’re so inclined, sell your shares quickly at a high point.

How Volatility Can Benefit Investors

While some investors may think they can use volatility to their advantage by waiting for stocks and funds to dip down before buying, then immediately selling at the next high point, it has proven difficult for such active management to beat the returns of a well-balanced mutual fund or ETF that tracks the market. Many investors therefore swear by a buy-and-hold strategy, which requires keeping investments long term so they rise gradually with the market.

Using a buy-and-hold strategy allows investors to double down on their investments in solid companies or ETFs when the market is at a low point due to volatility, setting themselves up for larger cumulative gains over time.

Those who do wish to use volatility to their advantage in a more active way have the potential to make big profits fast. However, you need to be very comfortable with risk and use some strategies to mitigate it. When investing during a volatile market with the intention of trading in the near term to make a profit, consider your position size and stop-loss placement. Doing smaller trades and using a wider stop-loss than usual can reduce your risk. Another good strategy is to seek out trending stocks or funds that have shown strong growth but haven’t accelerated faster than the broader market..

Takeaways About Volatility

• Volatility is how much the price of a stock or fund moves away from the average price, either up or down or both, in a given period of time.
• Volatility is a normal part of the stock market; investors can expect 15% movement away from the market’s average in any given year, and will see greater fluctuation periodically.
• Investors can weather volatility by sticking to a long-term plan, using a buy-and-hold strategy, and maintaining enough liquidity in their finances.
• Investors can benefit from volatility by buying on downswings and then holding onto their assets over time as the market gradually climbs.
• Those who want to use volatility to make big gains need to be very comfortable with risk and use strategies to reduce it.

Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Open a Magnifi investment account today.

 The information and data are as of the July 13, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.

With the globalization of business and investing, companies around the world can tap investors outside their domestic markets for financing. One way of doing so is by issuing international bonds.

Investors are eager to buy these bonds to diversify their portfolios with international exposure, allowing them to smooth out their potential risk from economic ups and downs at home.

What Is an International Bond?

An international bond is a bond issued by an entity that is not domiciled in the same country as the investor. For example, a U.S. investor may buy a bond issued by a German company in Euros. For the Germany company this is a domestic bond, and for the U.S. investor, it is an international bond. These bonds are usually corporate bonds and are commonly found in U.S. mutual funds.

As with all bonds, international bonds pay interest at regular intervals and pay the bondholder the principal amount at maturity.

Why Invest in International Bonds?

Investors benefit from portfolio diversification by adding international bonds to their portfolios. International bonds provide exposure to other countries and their economic conditions. A U.S. investor whose portfolio includes bonds issued in Asian countries will benefit when Asian economies are doing well, even if the U.S. economy is suffering.

A portfolio that includes international bonds from a range of countries and regions will be relatively insulated against economic downturns in any particular part of the globe.

Types of International Bonds

Domestic Bonds
A company or government entity in a given country can issue, underwrite, and trade these bonds to foreign investors. The bonds use the currency and follow the regulations of the issuer’s country. For example, a bond issued by a German company in Euros and subject to EU regulations is a domestic bond. When a U.S. investor buys the bond, it is an international bond for that investor.

Eurobonds
A company or government entity issues a Eurobond in the currency of one country — not the issuer’s domestic currency — and trades it in another country that is not the issuer’s country. As per the name, the issuers of these bonds are usually European companies, though the bonds can trade in non-European countries. For example, a bond issued by a German company in Japan denominated in U.S. dollars is a Eurobond, or more specifically a Eurodollar bond, indicating the type of currency.

Foreign Bonds
People sometimes use the terms international bonds and foreign bonds interchangeably, but these are different. Foreign bonds are issued in a domestic market in domestic currency by a foreign issuer, following domestic regulations. For example, a bond issued by a German company in the U.S. and valued in U.S. dollars is a foreign bond. There are a range of silly names for foreign bonds to indicate the country and currency in which they are issued, for example a Samurai bond is issued in Japanese yen, a Yankee bond is issued in U.S. dollars, and a Bulldog bond is issued in British pounds sterling.

Risk in International Bonds

While international bonds help investors diversify their portfolios, they can complicate things simultaneously. The bonds may be subject to different regulations and taxation requirements than the investor is used to.

And as they are denominated and pay interest in a foreign currency, their value fluctuates with the economic conditions in the issuer’s country, and with the exchange rates between the investor’s and issuer’s countries. That means that these bonds are subject to currency risk, or exchange-rate risk.

Currency risk is the potential for change in the relative price of two currencies in relation to each other. These fluctuations can introduce instability in profits and losses, requiring various strategies to hedge risk.

How to Invest in International Bonds

There are two ways to invest in international bonds: You can buy the bonds directly or you can invest in a mutual fund or exchange-traded fund (ETF) that focuses on international bonds.

The latter option can be a good idea for all but sophisticated investors, as it can be complicated to directly buy bonds issued in another country. Mutual funds and ETFs also have the benefit of lots of diversification, as there are many bonds bundled into each fund.

One thing to keep in mind when investing is that currency exchange is unpredictable, so you shouldn’t make the mistake of thinking you can guess how things will go. Don’t buy into a foreign bond fund to beat the market; only do it to gain more diversification. It’s wise to keep your allocation in those funds to a quarter at most.

Fees are another thing to think about. If you buy a mutual fund or ETF, you’ll need to pay a management fee, or expense ratio. Look for a fund with an expense ratio below — ideally well below — 0.50%. You may be able to invest in bond funds and ETFs without fees using a commission-free investing app like M1 Finance, Fidelity, TD Ameritrade, Robinhood, or Vanguard.

Key Takeaways About International Bonds

International bonds are a good way for investors to diversify their portfolios with foreign assets and gain exposure to international markets.
International bonds come with high currency risk, which means that changes in the relative values of the currency in which the bond is issued and the investor’s currency could make for some unpleasant surprises.
The simplest way to invest in international bonds is via bond funds for ETFs that focus on international bonds. These funds allow investors to diversify their portfolios greatly and usually have low or no fees.

Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Open a Magnifi investment account today.

The information and data are as of the July 13, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.