Market volatility is a common phrase in the news, often associated with some sort of impending financial calamity. But that’s got a lot more to do with what sells news than with what impacts your investment portfolio.
Focusing on market volatility, for most investors, won’t produce better decisions. But by understanding it, you can use it to improve your portfolio’s long-term performance.
Defining Market Volatility
Market volatility is a measure of variation in an assets price across time.
Let’s look at some examples to see how this plays out in the real world, starting with some assets that simply aren’t volatile. A savings account is an example of an asset without volatility. The account should slowly increase in value across time without any fluctuations on a daily, weekly, or monthly basis. The trajectory is smooth. The subsequent value is perfectly predictable.
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Moving up the volatility spectrum, we see some volatility in bond prices. There’s a degree of stability, but occasionally there are unexpected changes.
It’s usually not earth shattering, but values can and do change based on a variety of factors.
Once we get into the equity markets, volatility becomes more of a norm. The price of a share of a company’s stock isn’t predictable from day to day. There’s a good deal of fluctuation. Some days down a bit, some days a bit up. And some days the movement is pronounced. If it’s a quality stock, the trend will be upward across longer time periods. But it’s never predictable on a day-to-day basis.
How to Measure Volatility
The degree to which an asset’s price moves away from a steady state line of predictable change is its volatility. This is often expressed in standard deviations, which helps us to see the volatility separate from the numerical value of the asset itself.
If we only looked at price movement, there would be a distortion, as a move of $10 a share is very different on a stock priced at $5 than on one priced at $100.
There’s no reason for the average investor to run out and learn about statistics to understand market volatility and become a technical wizard.
It’s important for the average investor to know which investments have — or may have — volatility and how to work with that in their portfolio.
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The End Game
Investing has a clear end game. When it’s time for you to use the asset, you want to have as many shares as possible at the greatest price per share. That’s what your investment is worth. It’s no more complicated than that. The value of an equity holding is your number of shares times the price per share.
You select investments you expect to have a greater price per share in the future. Volatility can become your friend in helping you have more shares. If you’ll work with it. Really.
Market Volatility and Systematic Purchases
Let’s make the very safe assumption that you can’t time the market. We’ll make that assumption because it’s true. You can’t time the market. And that’s fine.
For most investors, their largest single investment is their 401(k) or other retirement plan. And for most of these investors, their contributions are made from their paychecks on a weekly or biweekly basis, with some minor exceptions for people who are paid in other fashions. The general method of contributing to retirement accounts is through systematic contributions.
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Contributing a fixed dollar amount into a volatile investment across a period of time is called dollar-cost averaging. This method takes advantage of the volatility in the market to produce a greater number of shares than you would have obtained by purchasing at the average cost during that same time period.
Arguments can be made both for and against dollar-cost averaging as a method of investing a lump sum into an equity investment.
But when were talking about systematic investments into a retirement account, you’re dollar-cost averaging whether you know it or not.
When you invest a fixed dollar amount into a volatile investment, your investment buys more shares when the price is low and fewer when the price is high. For example, if you invest $100 per paycheck into your 401(k), you will buy more shares when the price is $4 a share and fewer when the price is $6 a share.
Dollar-cost averaging doesn’t help if the market is moving steadily up. But that’s not what the market does. The market is volatile. And you end up with more shares by investing systematically into a volatile market. Thinking ahead to the end game where what you have to spend is the number of shares times the price per share, you will have more by having invested during volatile periods.
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Market Volatility and Rebalancing
Volatility’s impact on rebalancing gets a lot less attention. It affects fewer people, and it’s generally a lesser effect. But it’s still important.
Whether you manage an investment account through asset allocation or some other portfolio targeting or modeling strategy, you should still target a specific allocation on a long-term basis — at least if you’re looking to manage your long-term gains in context of risk you should be.
Portfolio Management Strategies
Portfolio management strategies work by capitalizing on relative price changes through rebalancing.
The easy way to think of it is with only two asset classes. Let’s say you invest in large-capitalization U.S. stocks and large-capitalization international stocks. They don’t perform the same way at the same time; they’re not perfectly correlated. One will perform better than the other, and they’ll swap positions in that respect.
You periodically rebalance back to your target. So if your plan was to invest 50/50, but international stocks outperformed U.S. stocks, you would rebalance by selling some of your international ones and investing more into U.S. stocks to restore your balance. You’d be taking some gain from the asset that increased in value and investing it into the relatively lower-priced asset.
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Rebalancing works the same if you are using 15 asset classes or 29 asset classes. The only difference is the math.
Generally, you rebalance periodically, quarterly, or some other measure, depending on a variety of factors. And market volatility, while not a factor in your rebalancing decision, has an effect.
When you’re moving money into the relatively lower-priced asset, the specific price can be higher or lower due to volatility. A relatively lower price will have you capitalizing on this by purchasing a greater number of shares, once again having volatility work to your advantage. There’s a mitigating effect on the sales side, but in net, the math is in your favor.
Even your friends can hurt you. You don’t always want volatility. This is one reason why we move assets from variable accounts as we approach our goals.
You don’t want next year’s tuition subject to market volatility. You don’t actually want it subject to any variability. There comes a time when your end game is better off if you make sure to keep what you’ve gained instead of accepting risk to try to get more.
Be cautious as you approach your goals. Reduce your risk — volatility is part of that.
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Final Thoughts on Market Volatility
Most investors put their money systematically into retirement accounts and reap the rewards of volatility without doing anything other than having the money taken from their paychecks. That volatility helps them accumulate a greater number of shares across time, giving them a greater total gain in the end.
Market volatility isn’t going to solve world problems, and it has its downsides. It keeps a lot of people awake at night. But it isn’t always a harbinger of impending doom.
Running from volatility is short-term thinking in a long-term game. If you invest for the right reasons and in appropriate investments, and you don’t take undue risk when your goals are close, you can capitalize on market volatility to help reach your financial goals. And anything that helps you reach those goals should be your friend.