A simple guide to volatility
Investors have much to think about when choosing and understanding investments; in particular, market volatility and the impact it can have on their investment. Extreme market volatility during the credit crunch demonstrated how markets can swing wildly.
Understanding volatility is therefore, vital to the overall process of choosing the right investments, whether investors decide to make their own investment decisions or to consult a financial adviser. If investors are unsure, we recommend they consult a financial adviser if they can.
What is volatility?
Volatility is how sharply and how frequently a fund or share price moves up or down over a certain period of time (see example below).
What causes volatility?
Volatility can be triggered by any number of factors. The UK stock market, for example, can fluctuate because of various factors both home and away; the Eurozone debt crisis, the slowdown in the US and problems as far flung as China can all have a turbulent effect on markets. Periods of losses/downturns can be followed by upswings, also known as rallies, and vice versa. But this is the very nature of the stock market.
Can you measure it?
The most common measure of volatility is standard deviation. This measures how much the value of an investment moves away or deviates from its average value over a set period of time, i.e. how much it rises and falls. The more volatility, the higher the standard deviation.
The examples below show shares with lower and higher volatility. Share A has lower standard deviation (volatility) compared to share B which has higher standard deviation.
Forecast volatility attempts to use standard deviation to forecast future variation in returns. The higher a forecast volatility figure, the more an investment could move both up and down over time.
What does it mean for investments?
Generally investors are happier with lower volatility even if this means making less money over time. Investors worry most about volatility when markets are falling. When this happens, remember that any loss or gain is only realised when selling holdings.
Investing for the long term means short-term volatility is not necessarily a reason to panic and make drastic changes.
It can actually offer an advantage if investing a monthly amount. When prices go up, the value of investments rise and when they go down premiums buy more. This is often referred to as pound cost averaging. However, this can not be guaranteed.
How can I best deal with volatility?
Spreading risk through diversification, is often said to be the first rule of investment. Diversification across a range of markets and asset classes enables savings to go to work in different markets and crucially, reduce exposure to one individual area, as one asset class may go up while another goes down.
Strategies of long-term investing and regular saving will help smooth out any bumpy rides. Matching your clients' attitude to risk with suitable investments is crucial to getting the right portfolio for their needs.
Please be advised that the value of investments can fall as well as rise and your clients may not get back the amount originally invested.
- Volatility is how sharply and how frequently an investment moves up or down over a certain period
- Periods of losses can be followed by gains and vice versa
- Strategies of long-term investing, diversification and regular saving will help smooth out any bumpy rides
- Any loss or gain is only realised when selling investments
- By speaking to a financial adviser, investors can discuss their appetite to risk and investment options and find a solution that’s right for them