Understanding Market Volatility and Its Effects
You’ve probably heard the stock market described as “volatile” in recent years. But what does this mean for your portfolio, and how can you continue to protect and grow your assets during these times?
What Is Market Volatility?
Volatility in the market is the extent to which the price of stocks or other investments fluctuate in the short term. It’s often used to gauge the riskiness of a security or the market in general.
In a low-volatility market, you get price changes, but they tend to be small and in a single direction — generally up. In a high-volatility market, the prices of many stocks move more dramatically, and they may rise or fall unpredictably.
Popular volatility indicators can evaluate potential fluctuations in a single stock or the market as a whole:
- Standard deviation shows how much a particular stock’s price changes within a specific time period relative to its average change in price.
- Beta measures how volatile an individual stock is relative to the overall market by comparing it to a benchmark such as the S&P 500 Index. A stock with a beta of 1 is expected to move the same amount as the overall market. Higher numbers indicate more volatility, lower numbers mean less volatility, and a negative beta, which is rare, means an asset is expected to move in the opposite direction of the market.
- The CBOE Volatility Index (VIX), created by the Chicago Board Options Exchange, is one of the most closely watched indicators of future overall market volatility. It measures the expected fluctuation for the S&P 500 Index over the next 30 days. A VIX of 0–12 is low, 13–19 is considered normal, and a VIX of 20 or higher indicates an expectation of higher-than-normal volatility. At the onset of the COVID pandemic, the VIX hit 83 points.
How Volatility Affects Investment Returns
Volatility can send the value of your portfolio on an uncomfortable roller coaster ride. While positive changes may feel good, significant negative changes or dramatic ups and downs are much less enjoyable.
In addition to the emotional stress of volatility, several studies have suggested it can have a real impact on the value of your portfolio. One investment research firm recently found that higher volatility corresponds to a higher probability of a declining market, while lower volatility corresponds to a higher probability of a rising market.[1] In other words, higher volatility tends to lead to declining values.
Strategies for Managing Market Volatility
However, the right strategies can help protect your portfolio against volatility risk.
Diversification for Stability
Diversification is an investment strategy that can help stabilize your portfolio value when the market seems anything but stable. The basic concept behind it is the same as the adage, “Don’t put all your eggs in one basket.” Applied to investing, it means not putting all your money into the same kind of investment because if that one type declines, your portfolio value has no option but to decline with it. Fortunately, for the most part, different classes of assets move independently, and gains in one class may offset losses in another.
Most investors choose a mix of asset types such as stocks, bonds, cash equivalents, and alternative investments to diversify. Stocks and bonds, for example, usually move in opposite directions. When stocks are up, bonds may be down, and vice versa. On rare occasions, the two classes may move together, but having both in your portfolio may provide some cushioning against risk. The process of diversifying among asset classes is known as asset allocation, and the exact composition should be based on your financial goals and risk profile.
You can also further diversify within an asset class. For example, you can choose a mix of domestic and foreign stocks or small-cap and large-cap equities. You could also diversify with municipal bonds and commercial bonds.
The Importance of Long-Term Investment Goals
Another strategy that helps in a volatile market is to focus on long-term results. If you’re looking at your portfolio daily, the news may seem alarming at times. Some days, you could see a 15% drop in value, while others may show a 15% increase. However, it’s important to remember that most of this fluctuation should simply even out over time. The stock that’s down today may recover and set new highs in a week, month, or year.
The general trend of the market is upward. While the S&P 500 has had three losing years during the past decade, the average return from 2013 to 2023 was a positive 12.39%. And the average annual return since the stock index’s inception is 10.26%. So, assets may fluctuate widely within a year but still perform well in the long run.
Knowing this and setting long-term goals for your money — retirement, education, etc. — can help you get through volatile times with less stress.
Rebalancing Your Portfolio Regularly
Diversifying your portfolio once isn’t the end of the task. You should be re-evaluating your asset allocation at regular intervals to keep your portfolio on track. Many professionals advise that you do this at least once a year.
Since asset classes do not typically move together, they will each earn a different return. The inevitable result is that, based on market value, the proportions of each class within your portfolio will change over time. Rebalancing is the process of changing the weightings of your assets to maintain the composition that suits your goals and risk profile.
You’ll need to buy and sell assets to reset your desired composition. Be aware that capital gains taxes may be triggered.
Evaluating Investment Returns During Volatile Periods
As with any critical process, you should regularly review the impact of your volatility strategies. How do your results compare to the market in general, and how well are your strategies supporting your goals?
What Is a Good Return on Investment in Uncertain Markets?
Due to increased risk, a good return in a volatile market might be lower than in a stable market. However, it’s hard to say exactly what a good return should be since not every volatile market is the same. There are different catalysts, conditions, and results.
In some volatile markets, a return of about 7% — the historical average return of the S&P 500, adjusted for inflation — might be a desirable result, while in other periods of volatility, you might need to focus on preserving capital rather than high returns.
But it’s important to focus on what you can control in any volatile market. Rely on diversification, set your sights on long-term results, and rebalance your portfolio to stay on track. Sizable recoveries have historically followed steep declines, so try not to make investment decisions based on emotions of the moment. Taking money off the table in a volatile market may seem like a good idea, but it can reduce your returns over time if you miss out on all or even part of a recovery cycle.
Why Return on Investment Is Important for UHNW Clients
Having substantial assets makes you especially vulnerable to market patterns. Gains can be larger, but so can losses, and lower returns can make it difficult to meet goals you’ve set for yourself and your family.
Strategic investing can help you grow your wealth, mitigate risks, and minimize taxes. A financial advisor can help you employ the best strategies for your circumstances and create a robust, volatility-resistant financial portfolio.
To be custom matched with a financial advisor you can trust to support your goals with customized planning and put your interests above theirs, take advantage of our advisor matching program today.
[1] https://www.crestmontresearch.com/docs/Stock-Volatility-Perspective.pdf
The views stated in article are not necessarily the opinion of Cetera Advisor Networks, LLC, or CWM, LLC. and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be fid. Past performance does not guarantee future results. A diversified portfolio does not ensure a profit or protect against loss in a declining market.
Some alternative investments involve a high degree of risk, and returns can be volatile. Investing in an alternative investment may only be suitable for persons who are able to assume the risk of losing a portion or all of their entire investment.
Investors cannot invest directly in indices. The performance of any index is not indicative of the performance of any investment and does not consider the effects of inflation and the fees and expenses associated with investing.
