What Drives Equity Market Volatility?

Benjamin Franklin was wrong. In 1789, the polymath and first US ambassador to France wrote, “In this world, nothing is certain except death and taxes.” Franklin had overlooked the fact that since the establishment of the world’s first stock market in Amsterdam about 180 years earlier, his list of life’s “certainties” should probably have included market volatility, too.

Equity market volatility—the degree to which share prices fluctuate—is a normal and continual part of investing. Yet, it’s a bane to many investors. Volatility, especially in the short term, is unpredictable. While the media often tries to tie volatility to specific events and narratives, there is no single factor at play. While market volatility is random—coming from anywhere for any reason—numerous interrelated factors influence share prices by adjusting the difference between investors’ expectations and reality.

How equity markets work

Equity investors don’t pay for what they think a company is worth today. They pay for what they believe it might be worth in the future. Therefore, the equity market reflects investors’ future expectations. As new information appears, equity prices update to reflect that new potential future through the acts of buying and selling of a company’s shares. When new information doesn’t mesh with what investors had expected, prices can change, sometimes rapidly, as investors determine potential future impact. The more unexpected the information, the likelier it is to spur a bout of short-term volatility.

Market factors that can affect volatility

Some of the most unpredictable volatility drivers come from the market itself. Sentiment, or how investors feel, is often a cause of volatility. Investor sentiment is more about emotions than market fundamentals, which makes it inherently unpredictable. As such, it can inject strong bouts of short-term volatility without warning.

Supply and demand can also drive volatility. Increasing or decreasing the supply of a company’s outstanding shares can significantly influence share price. Supply typically increases when companies issue more stock to fund new operations, or through the initial public offering (IPO) process. All else being equal, increasing the number of shares (i.e., supply) dilutes company earnings per share, potentially affecting demand from new buyers. If demand stays the same while the number of shares increases meaningfully, stock prices could fall. If demand exceeds supply, stock prices rise. Supply changes occur at a slower pace than demand changes because supply takes time to increase and decrease, whereas demand can change quickly based on the aforementioned sentiment factor. But both can affect share prices.

Related, low trading liquidity can sometimes precipitate volatility, particularly in shares of smaller companies. Trading liquidity is the relative ease with which a market’s buyers and sellers can find each other and agree on a price. When there aren’t enough buyers or sellers to complete an order—more common for smaller companies’ shares with lower trading volume—the difference can grow between a seller’s asking price and a buyer’s offering price, fueling price fluctuations.

Company factors and economic data that can trigger volatility

Companies continually transmit new information to investors, which can spur volatility. Examples like quarterly earnings reports, press releases, industry leadership changes, and technological developments are a few opportunities for investors to reassess a company’s future business prospects.

On a larger scale, economic and financial data releases can lead to periods of volatility. Many economic statistics, including national wage and employment updates, and gross domestic product (GDP) updates are lagging indicators whose data lack any predictive power. While markets may move after a particular data release, it’s important to understand that markets pre-price future expectations. That means much of the market impact from lagging indicators may already be reflected in stock prices.

The key element to understand with both company-specific and economic data is the surprise factor. The more the new information deviates from current investor expectations that are already priced into markets, the greater the potential for surprise and short-term volatility.

Political changes that can move markets

Legislative and other political factors can also contribute to market volatility—both in the short and long terms. During an election cycle, as candidates jockey for positioning, volatility can break out as investors try to assess the potential impact of a candidate’s policy platform and their likelihood of winning. Proposed legislative and tax changes can also affect sentiment and spark volatility. However, because new legislation can take a long time to enact and is subject to so much scrutiny, there is little surprise power to move markets.

Coping with volatility

Since volatility is unpredictable and is a typical feature of the equity market, long-term investors who require equity-like growth need to find ways to cope with it. Fisher Investments UK suggests a few strategies you can use to build patience and increase clarity of thought in your investing decisions.

• Think long term. Remind yourself of your investment time horizon. If you need to grow your portfolio over the long term—20 years or longer—owning equities is likely an important part of your investment plan.
• Remember, market volatility is normal. A certainty, in fact. Staying disciplined through volatility is always prudent. You can and should mentally prepare for corrections (short-term, sentiment-driven drops) and bear markets (longer-term fundamentally driven downturns)—you’ll experience both if you’re a long-term investor.
• Take solace in the long history of capital markets. Corrections are temporary, and even bear markets eventually end. Historically, markets tend to go up more often and by a greater margin than they go down. Owning equities for the long term is one of the best ways to benefit from economic growth and innovation.

Volatility isn’t pleasant for investors, but hopefully these practices can help you focus on the long term and take comfort in equities’ exceptional performance history. Fisher Investments UK believes patience and discipline are often the most prudent approach and vital to investing success over the long term. Coping with volatility is more about managing your reactions to the market than changing your investment strategy to suit the market. Or, as Ben Franklin said, “Happiness depends more on inward disposition of mind than on outward circumstances.”

Interested in other topics by Fisher Investments UK? Get our ongoing insights, starting with a copy of Your Net Worth.

Follow the latest market news and updates from Fisher Investments UK:

Facebook: https://facebook.com/FisherInvestmentsUK/

Twitter: https://twitter.com/FisherInvestUK

LinkedIn: https://www.linkedin.com/company/fisher-investments-uk