High market volatility has characterized the last few years, owing to various macroeconomic, financial, and health-related factors. This has been (and continues to be) a challenging period for investors, with the majority of portfolios suffering significantly due to the current circumstances. Others, however, have reaped the benefits as well.
In the financial markets, the concept of volatility versus stability is a recurrent topic. Historically, the stock market has been characterized by a cyclical pattern, with periods of calm followed by high price volatility.
Bull markets are generally associated with minimal volatility, while unpredictably negative price moves typically accompany bear markets. As such, many consider volatility to be undesirable and favor stability. However, it is not as straightforward as that: Volatility does not indicate any market direction. It is merely a measurement of the magnitude of price movements.
This article will discuss the notion of volatility and its role in the financial markets. We will then cover real estate, a popular asset class for investors in high-volatility environments.
VOLATILITY, AN UNAVOIDABLE ELEMENT OF THE STOCK MARKET
Stock prices are set in the marketplace, where the seller’s bid and the buyer’s ask are matched. While fundamental variables, or a stock’s underlying characteristics, play an important impact in its movement, many external factors also heavily influence it. Inflation, trends, market mood, macroeconomic events, government and regulatory actions, and daily news all substantially impact the market’s day-to-day movements. And when significant changes occur in the value of a stock, it is referred to as volatility.
Volatility, by definition, is the degree of uncertainty or risk associated with the magnitude of changes in the value of a security. When volatility is high, it implies that the value of a security can swing dramatically in either direction in a short period, whereas lower volatility means that the value of a security is more stable. Fear is typically linked to volatility, as it tends to surge during bear markets, stock market collapses, and other major downturns. On the other hand, market stability is a state in which transactions are not significantly disrupted, and financial asset prices do not experience large fluctuations.
The VIX, or the CBOE Volatility Index, is the most widely used metric for determining market volatility. It is, in fact, a gauge of investors’ and traders’ future bets on the direction of markets or particular companies. The Chicago Board Options Exchange introduced the VIX to gauge the predicted 30-day volatility of the US stock market based on real-time pricing of S&P 500 options and puts. A high VIX index suggests that the market is volatile.
Figure 1: VIX (CBOE Volatility) Index, 2019-2022. Source: CNBC
Since the Covid-19 outbreak, the VIX index has maintained high average levels, as shown in this graph. It has been hovering around 20 so far in 2022, indicating significant levels of market volatility as compared to historical data. We can also mention the 2008 crisis when the VIX reached new highs.
These levels have prompted investors to seek out alternative asset classes, which act as a hedge against turbulent financial markets. And real estate is the perfect candidate.
REAL ESTATE, AN EXCEPTIONAL PORTFOLIO COMPONENT AMID VOLATILITY
Especially in the face of volatile markets and shifting conditions, savvy investors aim to generate the most appealing risk-adjusted returns. Real estate has traditionally played a significant part in a diverse investment portfolio for individual investors to accomplish this goal. Over the last two decades, real estate has outperformed stocks and bonds in terms of annual returns while suffering substantially less volatility.
Figure 2: Stocks (S&P/Russell) vs. REITs index comparison. Source: Nareit
The lower volatility is due to the fact that real estate assets are more illiquid than equities since they are traded less frequently, resulting in fewer price movements. As a result, real estate is commonly regarded as a more enticing long-term investment due to its lower sensitivity to price fluctuations.
It is also important to note that, in terms of correlation, real estate values are unlikely to respond to daily stock market price movements; it is well known that the two categories have a minimal correlation. While significant events may impact property values, daily fluctuations in stock prices usually have no influence.
FINDING A BALANCE
It is important to note that volatility is necessary for economic growth. A market without volatility would eliminate the risk/return dynamic, implying that losses would be small, but so would gains. Therefore, just like everything else, it is all about boundaries. An extremely volatile market is hazardous to the economy and its participants. And when this happens, as it did recently with the Russian-Ukraine crisis, many participants rush to hedge-friendly asset classes.
Real estate assets can be a pleasant haven for investors who have been taken aback by recent stock market volatility. They provide many benefits, including tax benefits, asset appreciation over the long-term, inflation protection, and solid built-in, risk-adjusted income characteristics. In terms of stability, it is one asset class that has truly stood the test of time with consistent returns, offering a foundation for an investment portfolio in times of volatility.
