Volatility – Friend or Foe?

Ever present yet often misunderstood, volatility is the basis for many investment strategies.

The word volatility often has connotations of the unpredictable, or something potentially damaging that is out of our control. There is truth in this, but that is only part of the story. Volatility is an ever-present feature of stock markets that, in its essence, is a measure of risk. All investments encompass volatility, and the more volatility that comes with an investment, the more returns an investor should potentially receive.

For inexperienced investors, volatility can lead to irrational decisions, such as locking in losses by hastily selling when a share price has dipped. But all it takes is an understanding of what volatility is to turn it into a powerful investing tool. Given that investing is all about balancing risk and reward, the more you understand about volatility, the better able you will be to navigate the ups and downs and use it to your advantage.

What causes volatility?

Volatility can evoke strong emotions and strong emotions can lead to poor decisions. There are multiple factors that can cause volatility, and it can affect just one company, or it can affect stock markets as a whole.

Market-wide volatility is caused by a wide range of factors, frequently large-scale and global in nature. This can include major economic and political events, natural disasters, and extreme weather to name a few. Although rare, periods of market-wide volatility occur frequently enough to be in the back of investors’ minds when implementing investment strategies.

Volatility that occurs at a company level is typically driven by factors specifically affecting that business. This could be a rise or fall in profits, a corporate scandal, threats to business mode or a threat or crisis in its supply chain.

How volatility affects your portfolio

While your first instinct may be to avoid volatility at all costs, this is likely to cost you in real terms. Volatility is a normal aspect of financial markets that affects every type of asset. As noted earlier, securities with lower volatility, such as government bonds, often do not deliver big investment returns over the long run, while securities with higher volatility, such as equities, tend to perform better over the same period.

A savings account may be considered an investment with the lowest volatility. However, as a result of monetary policy and the introduction of zero interest rates returns on cash deposits are non-existent at the moment. If your objective is to achieve a certain amount of capital growth, then it is necessary to accept a certain amount of volatility depending on your overall attitude to risk and your investment objectives.

We believe the best way for investors to protect themselves against volatility is to have a diversified portfolio that contains a mix of equities, bonds, and other asset classes, such as commodities, infrastructure, listed private equity and property. This approach reduces risk by blending assets that have different volatility levels and return expectations and respond differently to different economic developments, allowing you to ride out the peaks and troughs over the long term. In theory, a decline in one asset will be balanced by a gain in another, so your portfolio will, on balance, be working to your advantage. Remember that diversification cannot eliminate the possibility of a loss, and the value of your investments and fall as well as rise.

Given that volatility is unavoidable, we think the only way to approach is by keeping a level head and focusing on your long-term financial objectives. Warren Buffet summed it up nicely in his 1985 note to shareholders of Berkshire Hathaway when he said investment success will not come from arcane formulae or computer programs, but instead from good business judgement and an ability to insulate our thoughts from the emotions that swirl about in the market.