Market Volatility

by Thomas Riggs

Ah, volatility. A word that seems to spark fear in the hearts of nervous investors! Whilst — yes — the connotations of the word can be negative, understanding how volatility affects a portfolio is important to ensure you don’t make decisions that adversely affect your returns.

What is volatility?
Volatility and the long game
Navigating volatility

What Is Volatility?

Volatility refers to the upward and downward movement of price. The more prices fluctuate, the more volatile the stock market is, and vice versa. A higher level of volatility means that prices can change dramatically over a short time period in either direction. (Investopedia)

This is often associated with the level of risk, whereby the more volatile an asset, the riskier the investment; this is owing to how much the price deviates from its mean (average), evidencing a level of uncertainty and higher spread of values, rather than something more steady with less fluctuation. To measure volatility, you may look at standard deviation to measure spread around the mean, or its beta value which is a measure against a benchmark (e.g. the S&P 500).

However, just because an asset is riskier, doesn’t mean it is not a worthwhile investment — in fact, over the long term, volatility can play a part in generating greater returns.

Volatility And The Long Game

Trying to navigate the dynamic trading environment to avoid volatility takes a lot of effort, which may pay off in the same way day traders chase their returns in the short term. However, if you are investing for the long term, volatility doesn’t need to be avoided in such an active manner, seeing as it is generally generated from the day-to-day market ongoings:

Volatility is often indicative of day-to-day market trading, but longer-term, the markets tend to move in one direction or another for a year or more.

This long-term trend benefits the investor — whereby the markets are generally up for three out of every four years — meaning that volatility and/or negative years will not have a huge impact on the long-term goal.

For example, the buy-and-hold strategy has consistently evidenced that simply riding through turbulence will see you accomplish positive returns, versus trying to time the market (and as such, volatility). Volatility to the long-term investors plays a much lesser role than the short-term trader.

A long-term investor, on the other hand, doesn’t have to worry about this day-to-day volatility of the market. As long as the market continues to climb over time, as it has historically, your good investments will appreciate and you’ll have nothing to worry about.

That said, there are ways in which you can benefit from volatility, rather than simply ride through it.

Navigating Volatility

Understanding volatility helps to keep a cool head when the markets are volatile. As we have seen, over the long term, you may simply accept and choose not to worry about volatility, as history has positively shown.

However, volatility should be managed, not explicitly avoided. An easy way to manage volatility in a portfolio is to be diversified; diversification is also a method to manage risk, so it works hand-in-hand. As they say, don’t put your eggs in one basket.

Diversification allows the higher volatility of riskier assets to be offset by including uncorrelated instruments. Over the long term a diversified asset portfolio will have lower overall volatility, yet each asset class will still generate its own optimal return.

Another way you can benefit from volatility is by buying low. If you are lump-sum investing, for example, you could benefit from topping up your investments when there are bouts of volatility, as prices may fall and those assets are valued lower. If your portfolio has been planned for buy and hold, you can reap the benefits of purchasing investments when they are “cheaper”, boosting your overall long-term gains when the markets bounce back.

* * *

Don’t fear volatility; understand it’s a part of the investment process and can benefit your portfolio by keeping a cool head and — as always — keeping your eye on the long-term prize.

Need some financial advice? I’m here to help!

If you have any questions, are seeking wealth management, or just a chat — drop me an email at:

thomas@absolutefsl.com

Cover Image – Freepik

Investments Savings