A Financial Advisor's Guide to Market Volatility
What is volatility?
You may be asking yourself: What is market volatility? One way to describe market volatility is the intensity and frequency of an asset’s or market’s price movements. The wider the trading ranges and price swings, the more volatile the market environment.
Volatility gets a bad rap, as the term is often associated with sharp, accelerated downward price movements in a market. But sharp price increases equate to volatility, too.
How is market volatility calculated?
Volatility measures price movements over a specified period.
In statistical terms, volatility is the standard deviation of a market or security’s annualized returns over a given period - essentially the rate at which its price increases or decreases.
If the price fluctuates rapidly in a short period, hitting new highs and lows, it is said to have high volatility. If the price moves higher or lower more slowly, or stays relatively stable, it is said to have low volatility.
What causes market volatility?
There are several things that can cause volatility in the markets. Some examples of things that can cause volatility include:
1. Political and economic factors
Governments play a major role in regulating industries and can impact an economy when they make decisions on trade agreements, legislation and policy. Everything from speeches to elections can cause reactions among investors, which influences share prices.
Economic data also plays a role, as when the economy is doing well, investors tend to react positively. Monthly jobs reports, inflation data, consumer spending figures and quarterly GDP calculations can all impact market performance. In contrast, if these miss market expectations, markets may become more volatile.
2. Industry and sector factors
Specific events can cause volatility within an industry or sector. In the oil sector, for example, a major weather event in an important oil-producing area, can cause oil prices to increase. As a result, the share price of oil distributing companies may rise, as they would be expected to benefit, while the prices of those that have high oil costs within their business, may fall.
Similarly, more government regulation in a specific industry could result in stock prices falling, due to increased compliance and employee costs that may impact future earnings growth.
3. Company performance
Volatility isn’t always market-wide and can relate to an individual company.
Positive news, such as a strong earnings report or a new product that is wowing consumers, can make investors feel good about the business. If many investors look to buy it, this increased demand can help to raise the share price sharply.
In contrast, a product recall, data breach or bad executive behavior can all hurt a share price, as investors sell off their shares. Depending on how large the company is, this positive or negative performance can also have an impact on the broader market.
Volatility is a normal part of long-term investing
There is plenty to unnerve markets and cause volatility, from changes in commerce to politics, to economic outcomes and corporate actions.
Yes, it might be unsettling, but it’s all ‘normal’.
When investors are prepared at the outset for episodes of volatility on their investing journey, they are less likely to be surprised when they happen, and more likely to react rationally.
By having the mindset that accepts volatility as an integral part of investing, investors can prepare themselves and remain focused on their long-term investment goals.
Market corrections can create attractive opportunities
Volatility is not always a bad thing, as market corrections can sometimes also provide entry points from which investors can take advantage.
If an investor has cash and is waiting to invest in the stock market, a market correction can provide an opportunity to invest that cash at a lower price. Downward market volatility also offers investors who believe markets will perform well in the long run the opportunity to buy additional shares in companies that they like, but at lower prices.
A simple example may be that an investor can buy for $50, a share that was worth $100 a short time before. Buying shares in this way lowers your average cost-per-share, which helps to improve your portfolio’s performance when markets eventually rebound.
The process is the same when a share rises quickly. Investors can take advantage of this by selling out, the proceeds of which can be invested in other areas that offer better opportunities.
By understanding volatility and its causes, investors can potentially take advantage of the investment opportunities that it provides to generate better long-term returns.
Many investors are familiar with the emotional impact that often comes with market volatility. When stock markets swing in extreme directions or change suddenly, investors can feel anxious and make decisions based on emotion that can hurt their pocket. This is a natural reaction when the markets are volatile, especially when the future seems uncertain and negative news headlines are abundant.
Instead of panicking and immediately changing your investment strategy, it’s important to keep perspective and maintain your focus on the long-term, no matter how rocky the markets may become. When stock market volatility strikes, we recommend these five strategies to help you maintain smooth sailing.
1. Don’t Panic and Maintain Your Original Investment Strategy
Investing in the stock markets can produce a variety of emotions for any investor. When all you hear on the news is doom and gloom, the best thing you can do is work with your financial advisor or financial planner and trust in the long-term plan you created together. Also, remind yourself of investment statistics to keep emotions in check. For example, long-term investments produce solid returns over 20–30 year periods, despite experiencing market volatility during that time frame.
2. Keep an Active Approach When It Comes to Risk Management
Depending on age, personality, short-term, and long-term financial goals, each investor has their own risk tolerance. Whether you have a high or low-risk tolerance, be sure to maintain an active approach. If you become uncomfortable with your strategy, risk tolerance assessment, or investment portfolio, discuss that with your financial advisor or financial planner before making any rash decisions.
3. Have an Investment Policy Statement from your Financial Advisor
If you want to stay on track with your investments, regardless of what the markets are doing, you should have an Investment Policy Statement (IPS). An IPS is a document drafted between you and your financial advisor that outlines general rules for meeting your investment objectives. It includes criteria for monitoring performance, addressing risk, and communication between you and your advisor. Your IPS should also include a provision explaining when you should rebalance your portfolio.
If you don’t have an IPS, you could be leaving your investments to speculation. Without written objectives and guidelines, your investments are subject to the whims of your emotions, and how you “feel” you should be investing.
4. Maintain a Diversified Portfolio
Do you want to have a proven cushion that will protect you when markets take dramatic swings? Work with your financial advisor to create and maintain a diversified portfolio. A properly diversified portfolio should include a variety of large, mid, and small cap investments, both domestic and foreign. It should also have a variety of industries and investment styles.
5. Don’t Rely on the Financial Media; Rely on your Financial Advisor
When emotions are running high, it is easy to get sucked into the financial media’s message of doom and gloom, with so-called “experts” inciting fear and panic. Remember, no one has a crystal ball when it comes to the future of the markets, and even scrutinizing past events cannot fully dictate the market’s future. Reach out to your financial advisor, calmly review your current strategy, and don’t focus too much on stock market news.
Traditionally, most financial advisors tell you to hold onto your investments when market volatility hits, rather than adjusting your strategy. Historically, investors who stay the course and disregard market volatility typically reap the returns later on. That said, each investor needs a personalized investment strategy, so it’s always best to discuss everything fully with a financial advisor.
Remember: Volatility Is Inevitable
Market volatility can be unsettling, but it’s critical to remain mindful of the long-range game while keeping in mind that volatility is an inevitable component of market cycles and long-term investing. Patience and discipline are key in times like these.
References
Assessing Your Risk Tolerance – https://www.investor.gov/research-before-you-invest/research/assessing-your-risk-tolerance
5 Investing Do’s and Don’ts To Deal With Stock Market VolatilityBy Lynnette Khalfani-Cox – https://www.ebony.com/career-finance/5-investing-dos-and-donts-to-deal-with-stock-market-volatility/
