Why Volatility Isn’t So Bad
Many investors expect the markets to be more placid than they really are. In periods of volatility, these investors may feel that they are caught off guard.
In reality, markets are volatile by nature. Over the past 40 years, S&P/TSX Composite total returns have been about nine percent on average. If one were to expect low volatility, annual returns would cluster closely around that average. However this hasn’t happened. Since 1970, over 60 percent of annual S&P/TSX Composite total returns have been either greater than 20 percent or negative. Simply put, there is a higher likelihood of large movements in market returns.
Yet volatility remains a dirty word. Volatility in the stock market is often the source of investor discomfort and, in extreme cases in the past, has led to panic selling. The Chicago Board Options Exchange Volatility Index (VIX), a measure of near-term market volatility expectations, is often referred to as the “fear index”.
But volatility isn’t necessarily all bad. Volatility in the stock market provides the opportunity for higher returns that all investors seek within their investment portfolios. Remember that a higher return can be the reward for investing in riskier, more volatile assets.
Volatility can also be a value investor’s friend. Solid businesses may experience short periods of undervalued share prices, allowing investors to exploit the opportunity and enter the market.
Of course, there is no denying that volatility causes much anxiety to investors when swings are towards the downside. But there are ways to protect yourself.
Longer-term investing smooths out its effects. By committing to a well thought-out plan that spans a greater time horizon, investors can generally ride out sharp periods of volatility. Time is on the investor’s side.
Diversification also helps to manage volatility. Last decade’s collapse of the dot-com bubble demonstrated the importance of being well-diversified and not investing in one industry, as an example.
There are also ways to help protect yourself in situations where abnormal events, or “Black Swan” events, cause temporary but extreme periods of volatility. In this issue we discuss some of these tactics.
Maintain a positive outlook when volatility occurs. Market uncertainty will always be with us. But with a proper plan and a bit of patience, volatility may not be such a bad thing.