Understanding market volatility
Volatility refers to how ‘changeable’ something is. When we describe a person as volatile we mean they’re unpredictable, while a volatile substance can change from one state to another easily or could even be dangerous.
It means the same thing when we’re referring to different types of investment. Riskier investments have higher volatility than lower risk investments because their values change more rapidly. The value of a small risky company may ‘explode’ upwards and make you lots of money, while it could just as easily ‘implode’ and lose you money.
The term volatility can also be used to describe the stock market, with periods of higher or lower volatility affecting all investments. Think of the FTSE 100 index ordinarily rising or falling by small amounts day to day (say between –50 to +50 points) but suddenly going through a period where it’s changing –300 to +300 points day to day, which are much bigger swings up and down. The stock market could be considered ‘volatile’ during a time like this.
Causes of market volatility and its impact
While ups and downs in the stock market are an accepted norm, sometimes the ups and downs become much bigger, like in our example above. This is usually due to an increase in uncertainty or rapidly changing situations like the outbreak of conflict, a material change in government policy, trade disputes, or markets trying to digest new information (good or bad) over a short period of time. For example, if central banks change interest rates unexpectedly, it reduces or increases the attraction of some investments over others, and markets need to react quickly to ‘re-price’ these investments up or down.
High volatility means bigger price swings, which means more chances for gains and losses. However, reacting to markets to try and time investment decisions comes with a lot of risk. No one can predict what the market will do from one day to the next, and the best course of action for most people is to let the ups and downs happen, staying focused on their longer-term financial goals.
Risk, reward and investor strategies
The relationship between risk and reward is important in investing. Generally, higher risk (volatility) can lead to higher returns (reward). For example, stocks usually offer better returns than low-risk investments like government bonds, but they also come with higher volatility. Understanding this can help investors make smarter choices about their portfolios.
Diversification is important, and spreading investments across different asset classes can reduce the impact of volatility on a portfolio. Regular investing, known as pound-cost averaging, means investing a fixed amount regularly no matter what the market is doing. This can help lower the effects of volatility by averaging out purchase prices over time. It’s really important to also keep a long-term perspective. Short-term market changes can be stressful, but focusing on long-term goals can help investors stay calm, avoid impulsive decisions and ride out any short-term volatility.