Market volatility can be difficult for investors to endure. Read here to learn more about what market volatility is and how it could affect your portfolio.
Few things stoke as much fear in the hearts of stock market investors as market volatility. Consider financial media’s sensationalism when covering market pullbacks and corrections—their use of the word “volatility” seems intended to scare investors. However, market volatility is not always negative—read on to learn more about what volatility is and how it could affect your portfolio.
At a basic level, market volatility is the degree to which security prices rise or fall over time, or how much returns vary from their averages over time. Market volatility can occur in several different types of investments or market indexes, not just stocks.
Security prices can rise and fall over time—sometimes quickly, sometimes slowly and often unpredictably. Even though investors often associate the term with risk or loss, volatility can be positive or negative—prices could move up or down. Additionally, prices may swing unpredictably from day to day but can settle over time. As you look over longer periods, even the most violent swings can look like smoother fluctuations along a broader trend. If individuals can tolerate investing through short-term swings, they could be rewarded with higher returns over the long term.
It is natural to fear volatility, as times of uncertainty and change can be extremely challenging. However, volatility is often unpredictable and can be short lived. Volatility today tells you nothing about the markets tomorrow. Trying to time investment trades to sidestep volatility is a nearly impossible task and could seriously harm investment returns over the course of a portfolio's lifetime.
Historical volatility can be valuable in evaluating the risk/reward ratios of potential investments over different time frames. For example, look at the Exhibit 1. It shows standard deviation (one way to measure market volatility) plotted against returns. As it illustrates, a portfolio of all low-risk bonds (as represented by the US 10-year government bond) is likely to show much less historic volatility than a diverse portfolio of all stocks (as represented by the S&P 500) over a 5-year period. This may lead you to assume bonds are “safer” than stocks.
But when observed over 25-year periods, stocks are likely to have a higher rate of return and less standard deviation than bonds. The historical volatility associated with a portfolio of stocks relative to fixed income smooths out over longer periods of time.
If you are investing for retirement, understanding an asset’s historical volatility and returns can be useful when selecting the allocation that is best suited for your needs.
Exhibit 1: Long-Term Asset Allocation
Source: Global Financial Data, Inc., as of 05/23/2019.
*Returns prior to 1988 represent Global Financial Data, Inc.’s S&P 500 Total Return Index, which simulates the returns of the S&P 500 Total Return Index had it been calculated back to 1926. The S&P 500 Composite Index is a capitalization-weighted, unmanaged index that measures 500 widely held US common stocks of leading companies in leading industries, representative of the broad US equity market. The performance of selected stocks is presented inclusive of dividends.
**Returns prior to 1941 use the Federal Reserve Board’s 10- to 15-year Treasury Bond Index. Returns from 1941 to present use the 10-year Treasury Bond Index. Performance is presented inclusive of dividends.
Markets can be challenging for investors to navigate. Even bull markets are subject to volatility, as uninterrupted periods of rising prices are rare in the long term. As stock markets rise, fear and volatility along the way are common.
Bull markets often overcome multiple corrections during their rise. Market corrections are sharp, sentiment-based declines of roughly -10% to -20%. We refer to the market overcoming these fears as climbing the “wall of worry.”
Although corrections are common in bull market years, they can still surprise and scare many investors. Corrections could be triggered by certain events such as geopolitical tensions, elections, economic news or natural disasters. Overall, corrections are short-term reactions based on sentiment rather than fundamentals—so they tend to be fleeting.
Fortunately, these types of events are often not big or bad enough to cause a full-fledged bear market, which is a fundamentally driven market decline of roughly 20% or more. Although investing through a bear market or a correction can be emotionally difficult, it may be worthwhile to weather the storm.
Since market corrections are often fear-based and can start or stop for any (or no) reason, trying to make trades in reaction to this volatility can sometimes do more harm than good. Even the most experienced investors could make poorly timed or harmful trades in their portfolios when attempting to time corrections.
Reacting emotionally to recent stock price swings may leave you trading at a loss if you buy or sell stocks at the wrong times. Abandoning a measured and long-term strategy to focus on short-term market opportunities or to avoid short-term declines can introduce risk into your investing at the expense of your longer-term objectives.
Often, the best move during periods of negative market volatility may be to stay invested to make sure you capture all bull market returns. Investment management is often a long-term practice and investor discipline almost always trumps timing.
It can be difficult to stay disciplined in a volatile stock market. The fear of risk or loss could lead to rash and emotional short-term decision making. Fisher Investments is committed to educating investors to guard against this behavior. Check out our infographic with additional insights on market volatility.
Our experienced research team has a deep understanding of market risks relevant to client portfolios and our client service professionals are available to help guide you through times of increased market volatility and keep you on the path to your long-term financial goals. Contact us today to learn more.