By Mia Kitner

We have all heard about the market volatility lately. But what does it mean? What exactly does volatility mean in terms of your portfolio? In raw terms, the definition implies an item or measurement scale that is prone to change. Let’s dig into it …

Volatility is defined as a tendency to change quickly and unpredictably. This can apply to:

• Price volatility
• The volatility of the stock market (prices of the indexes fluctuating at different rates)

What is the basic definition of volatility in terms of finance and investing?

To answer that, we need to understand how volatility is calculated. Looking into a statistician’s toolbox, we encounter measurements called variance and standard deviation. In layman’s terms, these are simply a measure of how far a set of actual data points lands from its expected mean or average.

If the data points are landing all over the map, further from the average, there is a higher deviation in the data set. If the data points are close to the average, then the opposite: low deviation. For the detailed readers out there, variance and standard deviation are not the same numbers per se, but the standard deviation is simply the square root of the variance.

In finance, volatility is a measure of the distribution of returns for a given security or market index. In simpler terms, volatility is how much uncertainty or risk is present regarding a change of a security’s value. The consensus is that the higher the volatility, the riskier the security.

Another way to look at it, volatility refers to the amount of uncertainty to the magnitude of changes in a security’s value over a given time frame. It can be measured over an hour or over a decade; it all depends on the portfolio manager’s time frame. However, regardless if you are day-trading or investing over a generation’s time, a higher measured volatility means that a security’s value can and will usually be spread out over a larger range of values.

The most common legacy measure of the relative volatility of a particular stock to the market is its beta. Beta moves toward showing the overall volatility of a security’s returns against the returns of a common benchmark (like the S&P 500). For example, a stock with a beta value of 1.1 has historically moved 110% for every 100% move in the benchmark, based on the price level. On the other side, a stock with a beta of 0.9 has historically moved 90% for every 100% move in the underlying index.

The good news is that with proper diversification (i.e., low correlation holdings in a portfolio), the variance (or volatility) of one’s returns can be reduced greatly. This is the reason one is strongly advised against investing too much of a portfolio into a single name or even an asset class (like small-cap stocks or corporate bonds). You don’t want that much in a single name or index or fund type if you want to lower your portfolio’s volatility.

OK, I understand volatility now, but what is the Volatility Index that I see on CNBC or in the paper?

In 1993, the Chicago Board Options Exchange (CBOE) introduced a calculated index, the CBOE Volatility Index, commonly known as the VIX. It is a measure of market expectations of near-term (30 days) volatility conveyed by the S&P 500’s stock index option prices. For over 25 years now, the VIX Index has been considered by many market participants to be the best barometer of investor sentiment and market volatility. It has also grown to be known as the “fear index” by some.

Specifically, the VIX is calculated by measuring how much participants are willing to pay for index options on the S&P 500 index at any given time during the day. Are participants willing to pay more for a certain option contract over that product’s theoretical value? Are they reaching to buy protection for their positions?

How much they are reaching in price can be interpreted as how desperate they are to transact. This is what the CBOE VIX measures: how far above the norm in price are traders buying options.

Now, the VIX is supposed to be a volatility index so it should be measuring volatility on the upside too. Why, then, is it known as the fear index? Here is where human nature comes in—the madness of crowds, if you will.

Imagine a crowd waiting for a popular movie release or an exclusive nightclub to open. When the crowd starts going in, it is usually orderly and slow. No one is panicking to get in. Now imagine either of those two venues, full of people, and a fire breaks out. How is the exit of all those people going to look? It will most likely not be orderly. People may trample or shove each other in an attempt to reach the exit.

Let’s apply the same thinking to the stock market. Very rarely do we see up spikes in an index’s price. The buying is usually orderly and consistent over time, not panicky. When the music stops, though, the selling can be quick and very disorderly.

This is why the VIX is known as the fear index. Even though it is made to measure upside as well as downside moves using S&P 500 index options pricing, the moves that make the VIX spike most of the time are those from quick and heavy selling, not buying.

A scenario where the VIX can shoot up would be: A market opens down one morning, then more selling comes in, then portfolio managers try to hedge their long positions with index options. Then more selling begins, and those same portfolio managers will pay up to buy protective options (over what they normally would pay). That “overpaying” is what moves the VIX.

A couple of weeks ago, volatility became a hot topic in the news and resulted in many investors wondering what they should do with their portfolios. While it may be challenging to maintain serenity in such turbulent markets, it is vital to remember that volatility is inherent in investing and that reacting emotionally may end up causing more harm than the market correction itself.

On February 5 alone, the S&P 500 Index fell 4%, and the VIX spiked almost 116% (volatility went up). The volatility funds that lost over 90% were those betting that volatility would go down (inverse volatility funds). And with the quick spike in volatility, those investors began to frenetically look for ways to get out of those losing positions. Unfortunately, for some such as XIV (an exchange-traded note issued by Credit Suisse) and SVXY (an exchange-traded fund), those bets caused major damage to the tune of millions of dollars.

While market volatility can be a nerve-racking experience for investors, understanding how it works and not reacting emotionally to the news could help investors remain calm during the periods of short-term declines. Having a well-thought-out investment plan and a well-diversified portfolio are two good steps.

Note: In accordance with Rule 204-3 of the Investment Advisors Act of 1940, Northstar Financial Planners, Inc. hereby offers to deliver, without charge, a copy of its brochure (Form ADV Part 2) upon request. This is not a solicitation for any investment product. Always read the prospectus before you invest. Past performance is no indicator of future returns. Northstar Financial Planners is a fee-only financial advisor and sells no investment products.