UPDATE: What Investors Need to Know About Volatility

Have you been feeling seasick lately? If so, you're not alone. Volatility is making a comeback in financial markets amid a sharp selloff in Chinese stocks that has stoked concern across the globe.

Markets have been relatively stable for the past three years, with the price of both U.S. stocks and bonds climbing fairly steadily. But as with any party that’s been going on for a long time, things have gotten a little weird.

Fears of weak global growth and a continued oil selloff have prompted several sharp market moves. And with uncertainty lingering as to whether the U.S. Federal Reserve will push forward with a plan to raise interest rates, it’s easy to imagine that financial waters could remain choppy for some time yet.

What Is Volatility, Anyway?

When people talk about market volatility, they're really talking about how much investors expect demand for a particular asset — and therefore, its price — to fluctuate over time.

The Chicago Board Options Exchange Volatility Index (VIX) estimates volatility by tracking options linked to the benchmark U.S. S&P 500 stock index. The VIX jumps when investors more frantically buy or sell contracts that hedge against or speculate on a sharp market move. The volatility index, also commonly called the market's "fear gauge," drops when that trading calms.

Why Do I Care?

Market volatility matters to investors for several reasons. The most obvious is that big swings in financial markets create uncertainty and can be potentially risky, particularly for investors saving for a significant event, such as retirement or paying for a child's college tuition.

It's important that investors look at market volatility with their investment timeframe in mind. An investor that doesn't need the cash they have invested in stocks for years is likely better able to stomach volatility in the short term. But an investor that needs to write a tuition check come August may want to explore less volatile alternatives to help secure a portfolio's value.

In an ideal world, everyone would buy assets when they're cheapest and sell them when they're most expensive. But choppy markets can derail even the most disciplined investor's game plan if he or she doesn't keep in mind their investment horizon. When portfolio values plunge suddenly, some investors might panic and look to sell before things get any worse. But if the market tumult passes quickly, investors risk selling their assets at the exact moment they are worth the least.

At the same time, when markets take an unexpected jog higher, investors may start to believe it is time to sell. It's never easy to know when to cash out of an asset that seems expensive and to buy those that look undervalued, but such decisions become even harder when prices are moving erratically.

Oil, Growth, and Central Banks — Oh My!

When volatility appears on the scene, it's important to understand what's driving it. Are markets having a temporary freak out over a geopolitical event? Or is there a more insidious long-term trend at work?

Three factors have played a big role in recent market volatility. First, global growth has been very weak outside the United States. When economies aren't growing, consumers and companies alike tend to spend less money, hurting the companies that supply them with goods and services.

Second, the price of crude oil, which has lost roughly half its value in less than a year, has weighed on investors' minds. Cheap gasoline is great for consumers and industrial companies that use a lot of energy, but it hurts the oil and gas companies that produce it.

The energy sector makes up 8.3 percent of the value of the S&P 500, a group of large American stocks frequently used to gauge the state of the overall stock market. Energy companies also make up about 20 percent of the U.S. high-yield bond market, and speculation as to whether or not they'll be able to repay their loans has stirred up debt markets.

Third, central banks are rattling financial markets, and may continue to do so in the coming months.

The European Central Bank said in January that it would implement a bond-buying program similar to the U.S. quantitative easing program, sending the value of the euro plummeting and European stocks higher. The U.S. Federal Reserve, meanwhile, has hinted that it will soon raise short-term interest rates for the first time since 2006.

All of these factors have helped pump up volatility in recent months. But the truth is, markets often soar and plummet precisely because something entirely unexpected happens. That means it always pays to be prepared, and understanding the effect volatility can have on a portfolio can help investors keep a cool head when the boat starts rocking.