Experienced investors understand that investing in equities consists of a journey more volatile than investing in other asset classes.
Equities Are Volatile
To help you understand the volatile nature of equities, let’s start by comparing equities with other asset classes, such as bonds. Investing in a bond involves lending money to the bond issuer, usually the government or an organization. In return, you get a payment with a set interest rate and your principal investment when the bond matures, and the issuer does not default.
On the other hand, investing in a share is buying a part of a particular company. The value of your stock is based on the company’s future cash flow. As a vast array of negative and positive factors affect share prices, it also means the worth of your investment can be positively or negatively affected.
Although investors always pay attention to a business’s prospect, the ability to accurately value an organization is not an exact science, which is why share prices are influenced by new information when available.
There are also other sources of market volatility, such as industrial changes or changes in the global or national economies they operate in. As organizations grow, equity investors are attracted to the opportunities associated; however, this does not mean volatility periods are unavoidable.
Now that you understand how volatile equities can be, it is time to find out things you have to bear in mind before investing in equities.
Understand Your Risk Attitude
You must build your investment portfolio with a sound understanding of your risk factor because portfolios with a higher percentage of equities tend to experience increased volatility.
Conversely, the additional risk also comes with superior returns compared to other asset classes. If you cannot withstand short-term valuation drops, you must have a portfolio that is weighted towards bonds and other cautious assets.
Equity Valuation
Equity valuation refers to the tools and techniques used by investors to determine an estimated value of a company. When you consider accounting standards, the book value of your equity in a balance sheet is assets minus liabilities. Nevertheless, you can use equity valuations to estimate a company’s value.
This process is based on the assumption that the fundamentals of the organization affect the equity or stock.
What is Volatility?
Volatility is the term that refers to fluctuation levels in a security during a particular period. It is typically measured using standard deviation, which, in itself, is a method of measuring dispersion around the average value.
When equity has high volatility, it means the stock has significantly moved from its average value. Typically, volatility refers to the day-to-day percentage change in a stock price. For example, you could say the volatility of Company A’s stock price is known as the deviation of returns.
How Exactly Does Volatility Work?
Stock returns are typically volatile, unpredictable, and completely random; however, the level of volatility tends to vary across stocks. For some, volatility can suddenly appear and disappear just as quickly. An increase in volatility is associated with a falling stock, but this is not a rule to go by.
Spiking volatility can be connected to news or information that could impact broad industries of the stock market or a particular stock. When there is bad news about a stock or company, many investors panic and rush to sell, which causes the price of the stock to drop. These falling prices might trigger more investors to sell their positions as well, restarting the cycle.
There is a parallel between the number of investors that sell their positions and the level of uncertainty of a company’s value, which then increases its volatility. In some cases, the price could drastically fall only to spring back up almost instantaneously.
Equity Valuation Methods
There are many methods to choose from when it comes to determining the estimated price of any equity, including:
Asset-Based Valuation
This valuation method combines all of a firm’s assets, typically on a liquidity basis. It concentrates on the organization’s fair market price or net asset value. The net assets are calculated with the net liabilities subtracted from that total to give the value of the organization.
Market Value Method
This valuation method compares an organization to other organizations within the same industry. You can use the market value method to find out the estimated value of an organization or a portion of a property.
Book Value Method
The book value method is simply the purchase price for the asset purchased minus depreciation.
Comparable Method
This method of equity valuation is founded on the theory that the value of any equity should be similar to other equities.
When it comes to comparable approaches, there are two methods. The first considers market transactions within similar firms or divisions acquired by rich investors, rivals, or private equity firms. The second approach is the more common one, and it considers the market comparable from rival firms and their peers.
Discounted Cash Flow Method
Discounted cash flow of DCF is an equity valuation method based on using prospective cash flows to determine the current value of the investment.
Is Volatility a Good or Bad Thing?
Now that we understand why equities are volatile and how volatility works, it is time to find out if volatility is a bad or good thing.
The truth is, stock market volatility can be both good and bad. It can also be neither of those things.
The way an investor views volatility is simply up to their investment strategy. For example, if you buy and hold stock for an average of about one year, you don’t need to worry about short-term volatility too much.
You understand that it is simply a short spike, either positive or negative, in your account value. Over a longer period, these short-term volatility spikes turn out to be advantageous for such an investor.
For a short-term investor, volatility can be bad or good, depending on the direction. In this case, it would be particularly important to closely follow the level of volatility before making an investment decision.
Why Are Equities Volatile?
The actual reason equities are volatile does not have much to do with the economy or the underlying fundamentals of the equities in question. Volatility comes from the individual investors themselves, or, more specifically, their investing behavior.
To understand why equities are volatile, you need to understand that volatility results from the drastic changes in the supply and demand of stocks due to investor decision-making.
Traditionally, asset pricing and other aspects of finance typically rely on the assumption that every investor is rational. In a rational world, supply and demand would only be influenced by the changes in a business’s intrinsic value.
However, the reality is an entirely different ball game. A factor that affects share price without rationality is known as animal spirits in the economist circle.
Animal spirit is a term coined by economist John Maynard Keynes, and it describes people’s willingness to act on impulse and take risks. When considering animal spirit and other human biases and irrational behaviors, they can contribute to a change in equity. The result is volatility!
When there is a large shift in supply and demand, the result is a drastic change in stock price, bringing volatility.
In the short term, demand and supply are the only factors that can cause the price of a stock to change. These fundamentals can determine a stock’s intrinsic value. However, if the stock market (investors) decides that a company should be worth more or perhaps they intend to buy more stock in the company, the market purchases more of that stock, which, in turn, raises the market cap. There is no limit to the market cap as it can become significantly larger than the business’s intrinsic value.
Conversely, the market cap of a company can be pushed by the equity market so it’s far below or above its intrinsic value, sometimes within a short time, by leveraging oversights.
Conclusion
When it comes to investing, particularly for long-term investors, volatility isn’t the most important metric to think about before diving into an investment opportunity. However, every investor must understand what it is.
As stated earlier, volatility is a measure of risk, and it helps to represent the change in a stock’s price. You can also view volatility as a representation of the market’s uncertainty concerning a market index or the price of a particular asset.
