Many investors know that managing volatility is central to achieving essential financial goals. But how much should you worry about volatility, and what can you do to prepare for it? Volatility represents the ups and downs of asset prices over time. And quite often it’s not the volatility that you should be worried about as it is periods of heightened market volatility.
What’s more, human expectations about the future tend to influence asset price movements. And it’s during periods of changing expectations and uncertainty that asset prices swing wildly. Being aware of the narratives driving the markets and having a plan in place before they change is central to financial success. The bottom line is that if you’re unprepared for periods of heightened volatility, you might be exposing your savings to unnecessary losses.
#1 Become Familiar with Volatility
Volatility is a normal part of investing. Asset prices do not move up in a straight line but tend to ebb and flow as they appreciate over time. Volatility is the price that you pay to earn a return on your investment. Indeed, what should be at the top of your list of in terms of investing concerns is not volatility itself, but periods of heightened volatility. Before diving deeper into the topic, let’s explore some basic concepts.
One way to quantitatively measure volatility is through a mathematical standard deviation of an asset’s return. This measure describes the historical tendency for prices to swing up or down versus their long-term average. The higher the standard deviation, the higher the volatility. This understanding is essential because the wider the swings in price returns relative to their long-term average, the less certainty you may have about future returns from one period to the next. And less certainty tends to go hand in hand with higher investment risk.
Let’s look at an example. From the turn of the century, the S&P 500 index has averaged a modest yearly gain of about 5.3%. This average return, however, masks some of the sharp market moves over the past two decades. If we looked at periods when market volatility was elevated during this time, the S&P 500 returned an average year-over-year loss of -3.3%. However, periods of lower volatility were associated with a higher average annual gain of around 10%.
The takeaway here is that volatility can be used to generate investment returns, mainly when it is low. More crucially, however, history tells us that sudden moves higher in volatility can detract from those returns. Therefore, awareness of the potential impact of a sudden rise in market volatility is vital to improving your investment outcomes.
#2 Understand Volatility Trends
Another way to look at volatility is through market participants’ expectations about the future. One widely tracked measure of such expectations is the VIX. The CBOE Volatility Index (VIX) uses a sophisticated method to express the future implied moves of the S&P 500 index. Often referred to as a “fear gauge,” sudden moves higher in the VIX are often associated with periods of uncertainty and heightened market volatility.
Compared to the backward-looking statistical measure of volatility mentioned earlier, the VIX is forward-looking. It is also based on investor’s directional expectations of the S&P 500 in the month ahead expressed through options market activity. A higher reading generally reflects greater pessimism about the expected direction of the markets.
Over the past two decades, the reading on the VIX has averaged a level of around 20. During the height of the Global Financial Crisis, VIX shot up to a level of 80 and, more recently, bested in February by the uncertainties related to the COVID19 pandemic. Historically speaking, a level below 20 has been consistent with favorable market conditions. A reading above 30 tends to occur during down moves in the market. Why is VIX important?
If you don’t know where you are, then it becomes that much harder to figure out where you might be heading. From a volatility perspective, VIX offers a simple way to know how much uncertainty might be priced into the markets at a given time. This understanding is useful before making investment decisions, particularly when history has shown that higher levels of volatility are associated with the potential for lower returns.
#3 Anticipate Changing Narratives
While financial markets are often viewed as a singular entity, the truth is that they are composed of thousands of assets, each with a host of participants. While algorithmic (computer-based) trading plays an increasingly essential role in the markets, the value of an asset is primarily driven by what human buyers and sellers think it’s worth.
Investors are more inclined to bid up prices when they feel confident about the future. For example, when there is certainty about a company’s earnings prospects, the policy environment, and the economy’s health, asset prices tend to grind steadily higher, and volatility remains low. However, during times of uncertainty about these factors, investors are less willing to pay more for an asset, prices fall, and volatility rises.
One way to measure broad expectations about the economic and policy environment and its potential impact on earnings is by evaluating work compiled by researchers at Northwestern, Stanford, and the University of Chicago. Their Economic Policy Uncertainty Index brings together three components that track 1) news about the economy, 2) tax policy changes and 3) economic forecasts. Their research aims to provide a quantitative measure of what is often a qualitative event (feeling uncertain).
When comparing this measure against the VIX, the data confirm what we know intuitively from a historical perspective: market volatility tends to rise during times of heightened economic uncertainty. From an investment perspective, when uncertainty rises, market participants often change their expectations about the future. And it’s during this time of shifting expectations when the price of an asset that may have otherwise seemed reasonable an hour, day or week ago comes into question.
Look for Changes in the Narrative
These periods of uncertainty are driven by a catalyst that often takes time to develop, and that’s why measures like the Economic Policy Uncertainty index can help. We only have to look back to the events in February to see how this relationship between uncertainty and heightened volatility played out. Coming into 2020, concerns about a recession had been on the rise, yet many economists expected only softer overall US growth.
In February, however, this hopeful view on the economy changed as Chinese provinces were under lockdown amid a healthcare crisis while the US began reporting rising COVID19 infection rates. As large parts of the US went into lockdown, prospects rose of a deep economic downturn, fueling a volatility spike by late February and ushering in one of the sharpest market selloffs in history.
The point here is that market sentiment is regularly driven by a broad story that is often evident in many quantitative indicators. When factors that support the dominant narrative are challenged, market participants that had been prepared for one set of developments may suddenly change their market positioning to re-evaluate their investment thesis.
When the story changes, the market direction will likely go along with it. Being aware of the narrative driving market sentiment, potential inconsistencies in the story, and how individual market participants might respond can help you better anticipate periods of heightened market volatility.
#4 Know What You Own
Another vital point to understand about volatility is that not all financial assets behave the same way when volatility rises. During periods of heightened market volatility, assets with higher risk levels tend to see wider price swings.
To this point, it is generally understood that stocks are riskier than bonds. This is because equity holders often share in the benefits of company ownership, like stock price appreciation and earnings paid out in dividends. During times of financial distress, like a bankruptcy, however, bondholders are often first in line to be paid back while equity holders might lose a sizeable share of their investment.
Other factors, like the type of issuer (government vs. private sector), company size, market characteristics, and country of domicile, all affect an asset’s risk characteristics. Taken together, the higher the likelihood that these factors might expose an investor to a loss, the higher an asset’s level of expected risk.
When uncertainties rise and market volatility spikes, individuals holding riskier investments are likely to experience wide swings in asset prices. How do we know this? Well, take, for example, the March market selloff. During the first quarter, the S&P 500 experienced a historic price drop of 20%. At the same time, US government bonds rallied nearly 8% as market participants shed risk assets in preference for perceived safe havens.
The critical takeaway here is that higher-risk assets tend to underperform when uncertainties arise and volatility spikes. If you’re anticipating higher market volatility levels, then it’s vital to know what you own. Understanding your risk exposures may enable you to trim less favorable holdings and align your investments with your long-term goals ahead of a rise in market volatility.
Improve Your Volatility Preparedness
We’ve addressed the various characteristics of volatility and its impact on the markets and investing. So, what can you do to help mitigate the effects of heightened market volatility in your investment portfolio?
Here are three suggestions:
First, don’t put your eggs in one basket. As we’ve written about recently, diversification is one crucial way to reduce portfolio volatility and smooth out investment returns for the long term. Studies have shown that increasing the number of securities held can reduce overall volatility in an investment portfolio. Therefore, if your goal is to invest for the long term, be sure to diversify your portfolio across various securities and asset classes to help reduce risk.
Second, build situational awareness. It’s easy to get caught up in the market’s daily price action or stay focused on a particular asset when your investments are doing well. Even so, markets are often driven by one or more underlying stories that can evolve. And it’s at those turning points in market narratives where volatility tends to spike. That’s why it’s critical to stay informed about broadly relevant market topics so that you don’t get caught unprepared when they change.
Finally, have a plan and act accordingly. Start with knowing what you own. Then, try to anticipate how those assets might perform during wild market swings and adjust your holdings accordingly. Heading into a period of heightened market volatility, it’s also vital to have a higher level of cash on hand. Doing so accomplishes two ends. One, it reduces the likelihood that you’ll need to sell an investment at an inopportune time to pay for necessary expenses. And two, it may allow you to have dry powder on hand for an opportunity to add discounted assets to your investment portfolio.
Volatility is a normal part of investing. It’s the price you pay to earn an investment return. That’s why what should be at the top of your list in terms of investing concerns is not volatility itself, but periods of heightened market volatility.
Whether you measure it using backward- or forward-looking means, the fact is that spikes in volatility are often drive by changing human expectations about the future and associated with lower investment returns. Being aware of the narratives driving the markets and having a plan in place before they change is central to investing success. The bottom line is that if you’re unprepared for periods of heightened volatility, then you might be exposing your savings to unnecessary losses.