There is a strong relationship between volatility and market performance. Volatility tends to decline as the stock market rises and increase as the stock market falls. When volatility increases, risk increases and returns decrease. Risk is represented by the dispersion of returns around the mean.
In a 2011 report, Crestmont Research examined the historical relationship between stock market performance and the volatility of the market. For this analysis, Crestmont used the average range for each day to measure the volatility of the Standard & Poor's 500 Index (S&P 500) index. Their research tells us that higher volatility corresponds to a higher probability of a declining market. Lower volatility corresponds to a higher probability of a rising market.For example, as shown in the table below, when the average daily range in the S&P 500 Index is low (the first quartile 0 to 1%) the odds are high (about 70% monthly and 91% annually) that investors will enjoy gains of 1.5% monthly and 14.5% annually.
When the average daily range moves up to the fourth quartile (1.9 to 5%), there is a probability of a -0.8% loss for the month and a -5.1% loss for the year. The effects of volatility and risk are consistent across the spectrum.
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Livio S. Nespoli has been a broker, registered investment advisor, and financial publisher since 1985.