Understanding Volatility
Volatility measures how much the price of an asset fluctuates over time. Typically, the more volatile an asset, the riskier it is considered as an investment. High volatility means the asset has the potential for substantial gains or losses over shorter periods compared to less volatile assets.As a relatively new asset class, cryptocurrencies are widely seen as volatile, with significant price swings over short periods. Stocks exhibit a wide range of volatility, from the relative stability of large-cap stocks (such as Apple or Berkshire Hathaway) to the often erratic nature of penny stocks. In contrast, bonds are viewed as lower-volatility assets, experiencing less dramatic price changes over longer periods.
How is Volatility Measured?
Volatility is commonly measured by "historical volatility," derived from analyzing past prices over a specific period (often 30 days or a year). Predicting future movements is referred to as "implied volatility." While not an exact science, implied volatility forms the basis for financial tools like the Cboe Volatility Index (known as the "fear index"), which forecasts stock market volatility over the next 30 days.Volatility can be quantified in a couple of ways:
Beta:
This method measures how volatile a stock is relative to the broader market, typically benchmarked against the S&P 500.
Standard Deviation:
This measure indicates how widely an asset’s price has varied from its historical average.
Why is Volatility Important?
Volatility is a key factor in assessing investment risk. Investors often take on higher risk if they believe the potential reward justifies the possibility of losing some or all of their investment. For instance, high-risk hedge-fund manager Bill Hwang lost his entire $20 billion fund in just two days.Retail investors are traditionally advised to diversify their investments within an asset class to reduce risk. A common strategy is to invest in a basket of stocks (or an index fund) rather than just a few stocks. Additionally, pairing investments in more volatile asset classes like stocks with less volatile ones like bonds can further mitigate potential downsides.As a relatively young asset class, crypto has experienced numerous sharp rises and falls, making it generally more volatile than stocks. However, increased trading volumes in Bitcoin (the largest cryptocurrency by market cap) and greater institutional participation appear to be reducing its volatility over time. Cryptocurrencies with lower trading volumes or emerging assets like DeFi tokens tend to be more volatile. Beginners are advised to only risk amounts they can afford to lose when experimenting with these assets.Factors that can increase volatility include positive or negative news coverage and unexpected earnings reports. High trading volume spikes usually correspond to higher volatility, while very low volume (as seen with penny stocks or smaller cryptocurrencies) also often results in high volatility.
Reducing Crypto Volatility
For some crypto investors, high volatility is part of the appeal as it creates opportunities for high returns. Despite Bitcoin’s declining volatility, it still often experiences double-digit percentage changes in a single week, enabling strategies like “buying the dip.”Less risk-tolerant investors can use strategies to limit the impact of volatility, such as dollar-cost averaging. Generally, investors with long-term strategies and confidence in an investment's growth over time don't need to focus as much on short-term volatility. Additionally, there are now cryptocurrencies designed to have low volatility, known as stablecoins (such as USD Coin and Dai), which have their value pegged to a reserve asset like the U.S. dollar.
