Volatility is an inevitable part of investing. For many it is a disconcerting phenomenon. But it is a normal component of financial markets. Understanding volatility can better prepare you for it. And when you’re prepared for it, you can plan a course of action for how to deal it. Periods of market volatility are temporary and occur within the longer timeframe of your financial planning and investing program. When viewed in this context, market volatility might be something on which you could capitalize.
What is Market Volatility?
The prices of individual securities (stocks and bonds) fluctuate. When aggregated, these price changes also cause market fluctuation. The degree to which prices change is volatility.
As prices change over time you can calculate a security’s average price. If the price of a security stays pretty close to its average, then it is said to have low volatility. If the price deviates greatly from that average, then the security has high volatility.
Volatility is typically measured in terms of standard deviation, a statistical measure of how widely a security’s price swings away from the average over time. Applying this statistical measure makes it easier to compare the phenomena of volatility, whether it’s applied to an individual security or entire markets.
Why Volatility is Important for Investors to Understand
There is a general relationship between volatility and opportunity. Higher volatility investments, in general, may have greater potential for gain than lower volatility investments. So, investors seeking to grow an investment portfolio may be rewarded by owning volatile investments. To help assuage concerns about changing prices over time it is helpful to understand that volatility is inevitable.
It is also helpful to understand that the correlation here is that assets with low volatility typically have correspondingly lower potential for growth. So, it may be difficult to achieve long-term financial goals investing solely in low volatility assets. Still, low volatility investments may have a place in your investment mix.
For example, they may be appropriate for an emergency fund or to finance consumption goals in the next year or two. In these cases, principal stability is typically more important than return. In the short-term it may well be acceptable to trade the return potential of a volatile asset for a greater likelihood that funds will be available when needed.
How to Approach Market Volatility
In general, investors with long time horizons, following a long-term financial planning strategy may be well served ignoring short-term bouts of market volatility. Staying the course for them may be an appropriate tactic.
As an example, consider an investor following a long-term financial plan. Assume this investor owns assets intended to finance specific future financial goals. Also assume these securities were selected for their long-term potential to help achieve those goals. Then assume a period of short-term volatility.
In this scenario the only things that might change are market index levels and the prices of the investor’s individual securities. The volatility doesn’t alter the plan. Only the investor can change the plan.
A big obstacle for many investors is emotion. An emotional reaction to market volatility can turn short-term fluctuations into actual losses. Investors need to consider volatility in context. Short-term price fluctuations don’t have to hinder your chances of reaching your long-term goals. Typically, staying invested when markets are turbulent may be appropriate.
Achieving long-term investment success may be the result of taking no action during periods of market volatility. No action, if done deliberately, may be the right action. Holding true to a long-term investment philosophy developed as part of a long-term financial plan may be appropriate for most investors.
A big key here is that the steps to dealing with volatility are incorporated into the planning before the investments are purchased. An investor with an appropriately diversified portfolio built in accordance with a specific strategy, may be better able to deal with volatility than someone who hasn’t planned properly.
How to Proactively Capitalize on a Volatile Market
Staying the course doesn’t preclude you from seeking opportunities appropriate for your individual situation. There are a few things you can do to take advantage of market volatility.
1) Investors may find a volatile market is an appropriate time to rebalance a portfolio. Rebalancing positions to maintain an original strategic asset allocation might make sense if your portfolio has strayed from its target allocation.
2) Market downturns may also present you with an opportunity to add desired positions to your portfolio. It can be like shopping when things go on sale.
3) Declining prices may also benefit you if harvesting tax losses can be used to offset realized capital gains within a taxable account.
To fully benefit from any of these tactics, you’ll want to make sure they fit into your long-term financial planning and investment program. You’ll also want to review each with your tax advisor and financial advisor to make sure they are both appropriate and beneficial.
What to Avoid During Periods of Volatility
Volatility is an inherent part of the financial market mechanism. It may be unwelcomed, but it is inevitable.
It’s natural for investors to worry about volatility. But they shouldn’t fear it. In certain specific circumstances, they may be able to capitalize on it. While it may be difficult, the most important thing is to avoid the kind of emotional reaction that leads to panic selling.
Investors seek to achieve their long-term financial goals in the context of well-planned strategies. Short-term market changes shouldn’t alter your long-term planning. If your investments are suitable for you and appropriate to achieve your long-term goals, then volatility shouldn’t trip up your plans.
Market volatility is typically a temporary phenomenon. Selling and suffering realized losses is permanent.
History’s lesson supports the notion that investors who stay the course – and ride out periods of volatility – are typically rewarded for their patience and fortitude over the long haul. The key is own high-quality investments and seek professional advice.
Working with experienced financial professionals can help you stay the course. They can provide guidance and encouragement to help focus your attention on your long-term goals.