Contrary to popular belief, market volatility may actually be the unsung hero in the battle of underperformance versus overperformance. Before casting judgment, get familiar with volatility. You may be surprised to learn how it can help you over the long term.

High & low

High volatility is bad and low volatility is good, right? Not always.

Stock market volatility tells us how often (and by how much) stock returns differ from their average values, without taking into account the direction of the difference (positive or negative).

For example, say you buy a car. From the date of purchase, its value consistently declines 10% every year. Because the decline is slow and steady, it’s considered a low-volatility asset. On the other hand, say you buy a house that increases in value 4% the first year, 7% the second year, and 2% the third year. It’s considered a high-volatility asset—and a good one to have!

An investment’s recent returns determine whether volatility marks a change for the better or the worse. In recent years, stock prices have steadily increased. Because average stock returns have been positive, a few days of negative returns will cause more of a spike in volatility than a few days of positive returns. By contrast, during a period of steady stock market declines, a few days of positive returns will produce a spike in volatility. The figure below demonstrates how 2 different portfolios with opposite performances can produce identical volatility measurements.

2 portfolios, identical volatility

Notes: Figure shows hypothetical return simulations for 2 portfolios. Volatility is calculated as the 10-day rolling standard deviation of daily returns.

 

Play it cool

You may only think about market volatility when stock returns are less than you expect for longer than you expect, but volatility is always in play. It can work for or against you, depending on how you react.

During the 2008 global financial crisis, we experienced the longest continuous period of above-average market volatility* since the Great Depression. If you bought the Standard & Poor’s 500 Index at the peak of its volatility in the fall of 2008 and held it until fall of 2009—when its volatility was less than its historical average—you would have earned a 33% return (before accounting for dividends).

The odds are in your favor

Your daily account balance may fluctuate (a lot) at times. But the odds will remain in your favor, even during market volatility, if you have a diversified mix of assets in your portfolio.

The table below shows how daily S&P 500 Index returns grow at a faster rate than volatility (aka, standard deviation of returns). As time goes on, the likelihood of realizing a positive return increases.

Time horizon

Median return

Standard deviation of returns

Positive return probability

1 day

0.06%

1.10%

54%

1 week

0.35%

2.27%

58%

1 month

1.29%

4.19%

64%

1 year

13.69%

16.50%

83%

10 years

119.01%

137.45%

91%

Sources: Vanguard calculations, using data from Bloomberg. Dates: January 4, 1988–February 16, 2018.


Any single day offers more than a 50% chance of positive returns. And with a 10-year horizon, you have a 91% chance of positive returns. Those are pretty compelling odds in favor of keeping a long-term outlook on your investments when volatility strikes.


*In this example, volatility is defined as the rolling 30-day standard deviation of price returns for the S&P 500 Index, with the historical average taken from March 1928 through February 2018.


Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Diversification does not ensure a profit or protect against a loss.

Past performance is no guarantee of future returns.