What is market volatility and how should investors approach it?
Jonathon Curtis, Investment Analyst, investigates recent market swings and considers whether volatility is something to be feared or befriended.
Volatility is part and parcel of investing. As we’ve had relatively little of it over the past decade, lots of investors have either never experienced large market moves before, or had forgotten what a real market shake down feels like.
Now volatility is back with a bang.
While recent events have certainly led to markets acting more extreme than usual, it’s important to remember market turbulence can and does happen. And if we’re set for a lengthy period of heightened volatility, it’s more important than ever to get your portfolio in the best shape to weather the bumps.
This article should not be viewed as personal advice, should you be unsure of an investment's suitability for you please seek advice.
What is volatility?
Volatility is the change in value of an investment over a period of time. If an investment experiences wild prices swings it’s said to be highly volatile, while if there are usually small changes it’s said to have low volatility. Stock markets are considered highly volatile – bond markets less so.
Different investors have different views on volatility. Some cautious investors try to avoid it. They prefer to look for steadier returns from investments that can hold up better during market falls, even if that means they’re left behind when markets rise. More adventurous investors view volatility as an opportunity to potentially earn greater long-term returns. Price swings can be up as well as down and falls in value can sometimes potentially create buying opportunities. Remember all investments can fall as well as rise in value so you may not get back what you invest.
Pain versus pleasure
Psychologists have suggested the pain experienced from loss is twice as great as the pleasure from gains. That’s why portfolio drops can really feel like a blow, and why volatility can be some investors’ worst nightmare.
While volatility is a measure of both up and down movements, most people associated it with sharp falls rather than rises. The CBOE Volatility Index, which measures the stock market’s expectation of future volatility has the nick-name “the fear index”.
But some investors quite like volatility.
Legendary investor Warren Buffett quipped, “Be greedy when others are fearful”. In other words, use market volatility to your advantage. Investments can become attractively priced during market wobbles, which could present an excellent entry point.
Remember to research before you buy to make sure that a stock is cheaper because it's being undervalued in this current climate, rather than due to more fundamental reasons like a company that’s in lots of debt or has poor management.
Volatility can be measured in a few different ways. One of the more common measures used by investment professionals is standard deviation.
Standard deviation tells you how much an investment’s range of returns have varied from its average over a period of time. The higher the figure, the more returns have risen above and fallen below the average – and therefore the more volatile it’s been.
Beta is another measure of volatility. It shows how much an investment has risen or fallen compared to its benchmark. A beta of 1 means it’s moved up and down by the same amount as the benchmark. The higher above 1 the beta is, the more volatile it’s in relation to the benchmark, and vice versa.
Some funds report their volatility measures like standard deviation or beta. These figures by themselves, however, are fairly meaningless. To put them into context they need to be compared with other similar funds, like those in the same sector. Not all funds provide volatility figures and those that do are looking at what’s happened in the past, so they don’t guarantee how volatile something will be in the future.
How volatile are my investments?
Look at how your investments performed during previous periods of volatility, like the 2008 global financial crisis and the end of 2018. Comparisons could give you a flavour of how they might perform in future turbulent times, but there are no guarantees as past performance is not an indication of what will happen in the future.
Funds and shares described as ‘defensive’ often hold up better than others during volatile periods. That could be because a fund invests more in bonds, or a company provides products and services that are in demand come rain or shine. Defensive companies might sell low-cost everyday consumer goods, healthcare or water for your home.
Some areas of investment are naturally more volatile than others. As a rule of thumb, smaller companies and emerging markets are more volatile than larger companies or developed markets. Corporate bonds, especially lower rated (known as ‘junk’ bonds) or unrated ones, are more volatile than government bonds.
Alternative investments like commodities, energy and gold can be highly volatile. They tend to be more sensitive to surprise economic or political events, or even weather.
What’s been most volatile recently?
Unsurprisingly, all investment sectors have seen increased volatility since the coronavirus-related market turbulence began in February.
UK stock markets, for both large and small companies, have seen the biggest increase in volatility and the highest volatility overall. A big part of that is down to the oil & gas, and financial service sectors. They've been some of the most volatile industries recently and make up more of the UK stock market than many other markets.
European companies of all sizes are next in line for both increases in volatility and overall levels. Markets in Italy, Spain and Switzerland have been particularly affected by the spread of the virus.
Smaller companies in North America and Japan have also seen much higher volatility than normal and higher levels overall than most. That’s largely down to North America’s high exposure to financial services and technology, and Japan’s exposure to industrials and real estate, which have been among the most volatile industries in their respective regions.
The property sector, usually one of the most stable, has also seen a spike in volatility. Investors are worried about tenants in the retail and leisure sectors not paying rent due the forced closures around the globe, and the potential long-term trend towards home-working hurting demand for office space.
And the least volatile?
At the other end of the scale, the global bond, sterling bond, targeted absolute return and mixed asset sectors have been the least volatile. This is in keeping with their long-term trend. Bonds, which make up much of targeted absolute return and mixed asset funds, tend to hold up better than shares during market jitters.
With now all-too-familiar scenes of empty supermarket shelves, it might come as no surprise that the least volatile industry has been food producers. Our need to stay connected, entertained and stocked up while stuck at home has also seen relatively low volatility for telecommunications, personal and leisure goods and electronic equipment.
Arguably the biggest surprise during the past month or so is China. Despite being the single most volatile sector over the long term, and the coronavirus outbreak starting there, China sits in the lower half of the volatility table since 20 February. The Chinese government’s swift action seems to have contained the virus well, and some investors expect a faster recovery there than other parts of the world.
Some investors consider jumping out of the market and selling everything during high volatility. They’re worried their investments could fall further and they don’t want the extra anguish.
The problem with this is you could miss out if markets suddenly rise again. There’s no signal once we’ve reached the bottom, and recoveries can sometimes happen quickly. On the other hand, you could re-enter the market thinking a recovery has begun, only to find out it’s a ‘false dawn’ and markets fall again.
In our view the best course of action is to focus on fundamentals, remember your investment goals, and invest for the long term. By staying focused on the long term, you avoid making potentially costly mistakes by getting your decisions or timing wrong. It also removes much of the time, effort and worry involved in making short-term investment decisions, helping you stay disciplined during turbulence.
Volatility in the market is completely normal, and something all investors should be prepared for. Of course, make sure your portfolio matches your risk appetite and long-term goals. If you’ve found price falls too much to stomach, make sure you have the right mix of investments moving forward.
Having the proper mix of investments in your portfolio that perform differently in different conditions means you should always have something working well. So even if most of your portfolio is caught out in the storm, you should at least have a life raft to keep you afloat until it passes.
If you want some help finding the right mix for you, or just want a pair of expert eyes to make sure you’re on the right track, you can always ask us for personal advice.
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