If you plan to invest in the stock market, you’ll likely hear about ‘market volatility’. And as an investor, it’s important to understand how it works and the difference between high and low volatility. Here’s a brief explanation.
What is market volatility?
A bit like roller coasters, financial markets have ups and downs, which is called volatility. Market volatility is a statistical measure that captures the size and speed of these ups and downs over a set period. Often market fluctuations will be more consistent, with no big surprises, but sometimes, these movements will be quick and abrupt, catching everybody off guard. By mathematical construction, the larger the dispersion of those moves, the higher the volatility.
What is low market volatility?
In the investment world, we talk about two types of volatility: high and low. High market volatility indicates that markets are experiencing dramatic swings over a short period of time. Conversely, low volatility means markets are moving steadily.
What does low market volatility mean for your investments?
Unlike high volatility which gets extensive media coverage, low market volatility is less exciting so often overlooked and can be less talked about. And yet, low volatility could have a significant impact on your investment journey.
As an investor, you may like the idea of low volatility, especially if it means markets are moving steadily upwards. But too little volatility isn’t always a good thing, in fact, if it persists for a long period it can even be bad news for investors. How, you ask? Well, periods of persistent low volatility can be a sign of market complacency, which can often contribute to the creation of speculative bubbles. A market bubble forms when those investments are in greater demand because expectations about their future value are excessively high. Put simply, investors will get very optimistic and confident about a game-changing acquisition or some innovation, and they will pour large amounts of money into these investments without any real analysis, driving prices up and fuelling the irrational exuberance already present on the markets. When investors realise investments have been priced far too high, the tide quickly turns, and everybody tries to get out by selling their holdings. Volatility rises and markets fall, which would in turn negatively affect your portfolio.
But it doesn’t stop there! A low volatility environment can push investors to make mistakes. If prices are increasing steadily over a long period of time, investors may be tempted to take a bit more risk and invest in less credible companies in the hope of higher returns. But again, reality always catches up and when investors realise these companies are likely to go bust, they’ll try to sell, and market volatility will increase as a result, bringing more risk in the equation for investors.
What about high volatility? Is it a good thing for investors?
High volatility can be scary – after all, nobody likes seeing their investments move erratically. But it’s not always bad news for investors. Although it comes with more risk and potential larger losses, high market volatility can also provide opportunities. Think about it, risk doesn’t just mean potential losses, it can also mean higher gains. And where you fall on the spectrum will depend on the investment strategies you’re choosing to adopt.
How to protect your investments from volatility
Whether it’s high or low volatility, it’s important to adopt strategies that can help protect your portfolio from market fluctuations.
Do you research
It’s very tempting (and easy) to listen to the noise and follow the crowd, but if you want to ride out market movements, it could be wiser to stick to facts. Before making any investment decision, try to do your homework and spend time researching countries, sectors, and companies. All of this takes time, and it can be a bit overwhelming, especially if you’re not a financial expert. But don’t worry, if you’re too busy or don’t feel confident enough to do your research on your own, there are digital investment platforms that’ll do the hard work for you, including examining investments and analysing market data.
Consider diversifying your portfolio
Another way to mitigate risk and shelter your investments from market movements is to diversify your portfolio by spreading your money across investment types and regions. Investments don’t always move in the same direction, some may fall, and others may rise. So, by having a good mix of shares of other investment types from different markets, you should be able to ride out the bumps, since poorly performing investments should be balanced out by others doing well. If you only invest in one or two companies or even focus on a single sector, then your portfolio will carry a significant amount of concentration risk, which is the opposite of diversification, and you could face greater losses if your investments were to decline.
Again, if you don’t have time to pick your investments, robo-investing platforms, like Wealthify, will build you a diversified portfolio and manage it on a regular basis.
Think about the long-term
Markets by nature are unpredictable especially in the short-term, meaning it’s almost impossible to predict where they’ll be heading next. And yet, many investors continue to think they can guess the perfect time to invest – spoiler alert: most of them fail to make accurate predictions. So, what could you do? Well, this may come as a surprise to you, but doing nothing and remaining invested over the long-term, regardless of market movements, could be the answer you’re looking for. Evidence shows that the longer you stay invested, the more likely you are to smooth out bumps and the greater potential your investments will have. For example, people who invested in the FTSE 100 for any 10-year period between 1986 and 2019 have had an 89% chance of making a gain – and this time frame includes periods of low and high volatility, like the Dotcom Bubble and the Global Financial Crisis in 20081.
1: Data from Bloomberg
Past performance is not a reliable indicator of future results.
Please remember the value of your investments can go down as well as up, and you could get back less than invested.