Volatility and Risk: How They’re Different
Knowing the difference can make you a better investor.
Whether it’s because of worries over negative interest rates, the global economy, the impact of high frequency trading or other reasons entirely, there’s a growing feeling stock market volatility is rising.
Have the market’s recent swings convinced you we’ve entered a new "riskier" era for investing? The fact is risk and volatility are nothing new. At times they’re closely connected. But they’re hardly the same. Understanding their differences can make you a better investor.
Confusing volatility with risk
Volatility is about how prices fluctuate through the ebb and flow of buying and selling. It’s unpredictable, but transitory. With volatility the only certainty is it’s sure to change.
Generally, an investment’s risk level has less to do with volatility and more to do with those factors which increase the chances of experiencing a permanent loss.
Here’s a hypothetical case that illustrates the difference. Take a struggling enterprise whose share price falls 10% every quarter. The drops are consistent each period, so the share price has had a smooth ride – in the wrong direction. The company’s eroding equity is a clear warning sign that it’s a risky investment.
Volatility can unduly distort judgements surrounding even the highest quality investments. Caught up in the chaos of the financial crisis, health care giant Johnson & Johnson saw nearly a quarter of its market capitalization evaporate in a matter of weeks. The underlying business? It remained solid throughout. The company’s revenues and earnings held up, it raised its dividend and continued to generate billions in free cash flow, making J&J anything but a risky bet.
There are other risks that have little to do with volatility. The trouble with holding cash, for example. It’s not volatile, but subject it to a 3% inflation rate and its purchasing power will be cut in half in a little more than 20 years.
Don’t let volatility cloud the big picture
Becoming absorbed in the gyrations of the market has a way of turning your focus short-term and away from what really counts.
While bouts of market instability can be unnerving, acting rashly to avoid it, perhaps by selling out of growth assets entirely, brings you face-to-face with perhaps the greatest risk of all – failure to achieve your financial goals. Earning a 2% guaranteed rate may be comforting in difficult times, but it won’t do much for you in the long run after factoring in taxes and inflation.
As the chart below shows, volatility has a constant presence in equity markets. However, it’s simply noise to a long-term investor who’s patient. Over the past 25 years the S&P 500 is up five-fold. But those gains didn’t come without volatility.
Investors have a tendency to let their recent experiences influence their judgement most. While the market’s latest movements have grabbed headlines, they haven’t been much different than the norm. The VIX, the volatility index for the S&P 500, averaged 23 through January and February, just slightly above 20, the mean since 1990.1
Ironically, when volatility is highest – during major crises – it often sets the stage for the next market advance.
1Federal Reserve Bank of St. Louis. CBOE Volatility Index. Based on average of closing daily values.
The lesson is if you can wait out the rough patches, volatility isn’t a threat. But it also means market turmoil can turn into a risk event when you have a short investment horizon.
If you’re about to retire, a sudden market drop could shrink your savings, maybe to the point of forcing you to rethink your plans. It’s the same problem if you’re considering drawing risk capital to pay bills. That’s why it’s essential to keep a cash cushion to take care of your near-term income needs so volatility will be less of a worry.
Strategies for navigating volatile markets
The evidence suggests volatility isn’t necessarily a bad thing. In fact, it can create opportunities. The trick is to stay committed to your plan when uncertainty threatens to derail your efforts. Here are six strategies that can help.
1. Hold uncorrelated assets
When you rely heavily on one asset class to drive returns, you expose your portfolio to greater risk and volatility if that part struggles.
Broaden your portfolio to include a variety of assets that will uniquely respond to changing market conditions, whether its deflation, inflation or rising interest rates. If Canadian stocks are your investments of choice, diversifying can be as simple as adding fixed income, or extending your holdings into U.S. dollars, real estate, and commodities like gold.
Owning investments that will rise in price even as others fall will help steady your portfolio. The table below demonstrates how a traditional balanced portfolio of 60% equities and 40% bonds can significantly improve stability over favouring a single asset class. For example, the balanced portfolio’s performance experienced half the variability of investing in large cap equities alone, with a similar annualized return.
2. Consider low-volatility solutions
Looking for more predictable equity returns? Low-volatility mutual funds and ETFs may be an option.
Low-volatility products lean on defensive sectors like consumer staples, utilities and health care which have generally held up better than the broad market during pull backs. These industries tend to be yield-rich, a positive since dividends would be a key contributor to overall returns if the market moves sideways for a lengthy period.
3. Buy the dips
Volatility is an ally of the astute investor. Keeping a cool head when others are nervous opens the door to adding quality investments at cheaper valuations.
A disciplined way to take advantage of the market’s ups and downs is through dollar cost averaging. Investing a little at regular intervals lets you buy more when prices fall and less when they rise, potentially lowering the average cost of your investment over time.
4. Stop staring at the numbers
Constantly watching financial markets and over-monitoring your portfolio hikes the odds you’ll turn temporary pull backs into permanent losses by reacting emotionally to volatility. Have confidence in your plan and let it work.
5. Rebalance regularly
A key to successful investing is finding an asset allocation that will help you reach your goals at a risk level you’re comfortable with. The problem is volatility can push your investment mix too far in one direction and knock that critical balance out of whack.
Review your holdings regularly and rebalance by selling some of what’s performed well and topping up what hasn’t, to bring your portfolio back into proper alignment.
6. Think outside the box with life insurance
When you think life insurance, you undoubtedly think about how it can provide income for your family or pay off debt if tragedy strikes. But permanent life insurance also has an investment side that can help you diversify away from market risk.
Take a participating whole life policy for example. A part of each premium goes to building a cash value that’s guaranteed and is tax-sheltered as long as it remains within the policy. While the cash value is typically placed in a diversified investment pool, unlike a regular investment it isn’t tied to the day-to-day moves of financial markets.
Ultimately, the policy value can be used for various purposes, from supplementing retirement income and charitable giving, to covering capital gains taxes from your estate.
Permanent life insurance acts much like its own asset class, helping maximize wealth for you and your loved ones, with peace of mind.
Focus on where you’re going
Investing is a path full of twists and turns. Managing volatility and risk is just a normal part of the journey.
If you want to do more with your money in uncertain times, speak with your BlueShore Financial advisor. We’ll show you how to handle the bumps in the road and help you stay focussed on your destination.