How do you know when market volatility is good? When it is in your favor, of course. Believe it or not, volatility is an essential part of the market. If this statement surprises you, let’s say from the list of synonyms for “essential,” we used “needed” or “necessary” instead.
See if this makes a difference in your reaction: “volatility is a needed part of the market,” or “volatility is a necessary part of the market.” Truth is, most people think volatility is bad.
Volatility can present opportunities for enhanced results when focused on the long term. What sometimes stands in the way, however, is the natural aversion to invest during volatile markets, so it might be a matter of altering perceptions.
It was “Modern” Once
A long time ago, financial advisors learned about Modern Portfolio Theory (MPT) and about its creator: Nobel Prize-winning economist Harry Markowitz in 1952. He devised a way to mathematically match an investor’s risk tolerance and reward expectations to create an ideal portfolio that focuses on the diversification of asset classes and securities.
Interestingly enough, MPT defines risk as volatility, and since there is a relationship between volatility and expected returns, every investor “must” accept uncertainty if they are to generate returns– in excess of the ‘risk-free rate.’ Ok. So, what on earth is that?
The risk-free rate is the interest on an investor’s money that would be expected from an absolutely risk-free investment over a specified period of time. However, the risk-free rate is a theoretical number since technically all investments carry some form of risk.
You could boil it down to this: investors must be compensated for a higher level of risk through higher expected returns. Markowitz simply said when the market gains, a more volatile portfolio may gain significantly more. When the market falls, the same volatile portfolio may lose more; prey to fluctuations.
When One Zigs, the Other One Zags
Enter: Idiosyncratic risk. Basically, when a loss in one asset is offset by a gain in another asset, essentially, when one zigs, the other one zags. When advisors talk about portfolios with a mix of stocks and bonds, they usually warn that when stocks go up in value, bonds go down. When the stock market goes down, volatility goes up.
Generally, bonds do not offer big returns, however, they do provide regular income. They have their risks too. But the point is, with bonds backed by the U.S. Government, they are guaranteed. Bonds are less volatile despite their lower returns and sensitivity to to interest rate moves.
Will volatility bring extreme uncertainty to investors in achieving their long-term goals?
Well, guess what? Lower volatility does not necessarily mean better returns either. In fact, low volatility has been known to represent the calm before the storm. The second popular school of thought is volatility is not risk. But it is a measure of only one type of risk.
Why do we fear volatility when we just learned it could very well also signal opportunity?
Fluctuation is the Stock’s Volatility
The stock market reacts whether the news is good or bad, and at the news that is directly related to the stock market. If the Federal Reserve suggests higher rates, you know what happens. Consumer fears or politics, you know what happens.
Normally, the price of a company’s stock will fluctuate over time anyway. This fluctuation is the stock’s volatility. The up-and-down price and the fluctuations between the open and close of a trading session is the stock’s “intraday” volatility.
Traders may use 70% as being comfortable for them trade. In fact, some traders feel that the higher percentage is less risky to enter the market. So is volatility considered risk?
If the price stays relatively stable, the security has low volatility. If the security hits new highs and lows quickly, moves erratically, and has rapid increases and dramatic falls, it has high volatility.
High-anxiety-producing volatility can actually mean greater profits when low enough.
Are You A Do-It-Yourself Investor?
Investors are either totally dependent on a financial advisor or completely independent.
Unlike a financial advisor, DIY independent investors do not make investing their full-time job. Are they good at it? Sure. Some are, and, of course, some aren’t.
Advisors admit they know DIYs who rarely discuss their dealings with their spouses. Hefren-Tillotson advisors take the time, preparation and personal attention necessary to get to know each and every spouse, because building relationships is vital to success.
What happens to the remaining spouse if the DIY-investing spouse gets sick or dies?
Advisors have had to face this over the years and say each situation is extremely challenging. The remaining spouse has no idea what he and she has, had, or what they own. And worse yet, no idea what to do with it all and who to call for help.
As one DIY investor and Forbes contributor said a few years back: “All it takes is learning to manage the risk side of the investment equation, developing a routine for keeping on top of one’s portfolio, having a contingency plan for “what if” situations, and seeking out a like-minded professional to use as a sounding board and trusted colleague.”
It sure sounds like a pretty good description of a financial advisor, doesn’t it?