Volatility: A Misunderstood Friend in Disguise

VolatilityWhen markets become rocky, the term volatility gets used a lot. For some investors, it’s a bit of a scary word, often used to describe sharp declines in the markets (which can be even scarier). On a scale of pleasantness, we’d guess that experiencing market volatility is up there with public speaking and going to the dentist for most people.

 

 

For all the term gets thrown around, volatility is rarely defined. So, what is it?

As described by one investing expert, volatility “is merely a synonym for unpredictability; it has neither negative nor positive connotations. “Volatility” simply refers to the relatively large and unpredictable movements of the equity market both above and below its permanent uptrend line. Equities can be up 20% one year and down 20% the next, randomly. Bonds very rarely behave like that.”

An analogy might be useful. If the weather is 22-24 degrees and sunny all summer long (we’d be okay with that!), it’s not very unpredictable. You could say it’s not volatile.

The same is true with financial markets. Markets that are calm are low on the volatility scale; markets that are seeing wild swings are said to be highly volatile. Volatility is always there; sometimes it just becomes way more pronounced.

Some people think that volatility in markets is a bad thing, probably because it’s associated with falling prices. This is a mistake. Here are some reasons why volatility isn’t nearly as scary as it seems:

  • It’s the Price You Pay for Higher Returns: it may seem counter-intuitive, but stocks provide better long-run returns because they are volatile. The higher returns in equities are your compensation for them bouncing around more than fixed income investments.
  • It Provides Great Buying Opportunities: We’ve all heard the phrase buy low and sell high. Yet in practice, it’s tough for many investors to do this, because when markets fall, its human nature to run for cover to avoid more losses. In fact, when markets are incredibly volatile, it can provide great buying opportunities because equities are basically “on sale” for the brave buyer.

 

How to Deal with Volatility

There are a couple ways that investors can deal with market volatility:

  • Expect it: this is especially important after a long period of calm in markets. Remember that heightened volatility will return at some point.
  • Embrace it: as we’ve mentioned, very volatile markets are actually your friend in the long-run. They give you opportunities you wouldn’t otherwise have, and make the returns on equities higher than they otherwise would be.
  • Have a Plan for it: here is where having an Investment Policy Statement that lays out your financial objectives is so important. When markets do become volatile, you can re-visit your plan and be comforted that the temporary setback in your portfolio has in no way harmed your long-term investment prospects. History bears this out: investors who stuck to a well-thought out plan in prior bouts of market volatility came out well ahead of those who panicked.

So to sum up: it may not be pleasant when it’s happening, but volatility is perfectly normal and, (like going to the dentist!), actually great for you in the long-run.