There’s a common refrain that echoes through the corridors of Wall Street and the casual conversations of Main Street:

“Stocks are just more volatile now.”

This statement, often heard, read, and believed, reflects a widespread perception among investors.

They tend to focus primarily on short-term volatility, and many harbor a growing fear that volatility is on the rise.

This sentiment has been fueled by significant market events, such as the 2008 bear market, the largest since the Great Depression, followed by substantial global corrections in 2010 and 2011, and a smaller but still concerning correction in 2012.

The rise of high-frequency trading and the presence of speculators are frequently cited as contributors to this perceived increase in stock market volatility.

…however, it’s crucial to challenge this narrative and recognize it as a myth.

Volatility, by its very nature, is volatile.

It’s normal for the market to experience periods of both higher and lower volatility.

Moreover, the assumption that higher volatility equates to trouble is a fallacy.

A closer examination of recent years reveals that the levels of volatility we’re witnessing are not extraordinary but rather fall within the normal historical ranges.

Understanding Volatility: More Than Meets the Eye

Let’s delve into a comparison to illustrate this point. Consider the years 2008 and 2009. Most investors remember that U.S. and global stocks plummeted in 2008 and then soared in 2009.

…however, contrary to popular belief, stocks were not more volatile in 2008.

In fact, the standard deviation, a widely used measure of volatility, was 20.1% in 2008 and slightly higher at 21.3% in 2009 when measured using U.S. stocks.

This surprising revelation underscores the need to understand standard deviation properly.

It measures how much something deviates from its average, whether it’s the historical volatility of stocks, sectors, or even the number of sunny days in a particular city.

A low standard deviation indicates little variation from the average, while a higher one signifies more variability.

As of the end of 2011, the S&P 500’s annualized standard deviation since 1926 was 15.6%. This figure includes the highly volatile years of the Great Depression bear markets, which skew the average upwards. However, the median standard deviation since 1926 was 13.0%, placing both 2008 and 2009 well above the median. This data highlights the inherent variability in stock market volatility and the fact that it is backward-looking. While it provides a historical perspective and a range of what to expect, it is not a tool for forecasting future volatility.

Volatility: Not a Predictor of Market Direction

The relationship between volatility and market performance is not as straightforward as many assume.

The most volatile year on record was 1932, with a standard deviation of 65.4%, yet the stock market was down only 8.9% for the year.

Conversely, 1933 witnessed a standard deviation of 52.9% and a remarkable rise in stocks by 53.9%.

These examples demonstrate that high volatility does not necessarily mean a market downturn.

For instance, in 1998, the standard deviation was 20.6%, and stocks were up 28.6%. Similarly, in 2010 and 1980, above-average standard deviations coincided with significant market gains.

On the flip side, lower volatility does not guarantee substantial returns. In 1977, the standard deviation was a below-average 9.0%, yet stocks fell by 7.4%.

The year 1953 saw a standard deviation of 9.2% with a stock decline of 1.1%, and in 2005, a low standard deviation of 7.6% corresponded with modest stock returns of 4.9%.

These instances illustrate that there is no predictive quality to volatility levels. Instead, standard deviation serves as a descriptor of past market behavior, without dictating future market movements.

Dispelling the Myth of Increasing Volatility

The notion that market volatility is trending upwards is another misconception.

While there have been periods of heightened volatility, such as in 2008, 2009, and 2010, these are not indicative of a long-term trend. Historical data shows that volatility has varied significantly over time, without a clear upward trajectory.

The Flash Crash of May 2010, often attributed to technical glitches and high-frequency trading, is a case in point.

Despite the dramatic intraday market drop, this event does not provide conclusive evidence of a sustained increase in volatility.

High-frequency trading, a frequent target of blame for rising volatility, has been present in various forms for years, including periods of relatively lower standard deviation.

The use of computers in trading is not a new phenomenon, and its impact on market volatility is not as straightforward as some might believe.

The Great Depression, for example, experienced extreme volatility due to a combination of factors, including limited liquidity, slow information flow, and wider bid-ask spreads.

Today’s markets, with a greater number of publicly traded stocks, more participants, and instant access to information, are inherently less prone to the intense swings seen during the Depression era.

The Role of Speculators in Market Dynamics

Speculators, often vilified for their perceived role in increasing market volatility, are an integral part of the financial ecosystem.

In reality, anyone who buys or sells a stock is engaging in speculation, anticipating that the stock will perform in a certain way.

Futures trading, a common form of speculation, involves agreements to buy or sell assets at a future date. These contracts are essential for various legitimate business purposes, such as smoothing input costs for volatile commodities or managing risk.

Speculators contribute to market liquidity and transparency, facilitating price discovery.

They are not financial wizards who consistently profit at the expense of others; like any investor, they face the risk of losses.

Furthermore, speculators do not exclusively bet on rising prices; they also speculate on price declines. The presence of speculators in the market, therefore, should not be viewed as a negative factor contributing to increased volatility.

Embracing Market Volatility

Understanding and accepting market volatility is crucial for investors.

Volatility is a natural and inherent aspect of the stock market, reflecting the dynamic interplay of various economic, political, and social factors.

Rather than fearing volatility, investors should recognize it as a component of the investment landscape, one that offers both challenges and opportunities.

In conclusion, the perception that the stock market is more volatile than ever is a myth that needs to be dispelled.

Volatility is not a reliable predictor of market direction, nor is it trending upwards in a significant way. The role of speculators and high-frequency trading in influencing volatility is often overstated.

As investors, it’s essential to approach the market with a clear understanding of these dynamics, focusing on long-term strategies rather than being swayed by short-term fluctuations. By doing so, we can navigate the ever-changing tides of the market with confidence and a well-informed perspective.