If you’re an investor, you know the impact that volatility can have on your portfolio. Ups and downs in financial markets, individual securities and even mutual funds can have you smiling one day, worried the next.
However, it is possible to manage volatility so price fluctuations won’t be such a concern. When you understand volatility and how it works, you can take steps to manage its impact.
Volatility is important because it is a measure of risk and potential reward. It is the tendency of securities to rise and fall over a short period. Large swings equal high volatility. More moderate swings represent lower volatility.
The higher the volatility, the greater the potential for short-term returns and the greater the risk that your investment will decline in value over a short period. If you have the potential to make a lot of money you often have the potential to lose a lot as well. Less volatile investments may not have the same potential for windfall profits, but they usually don’t have the same degree of downside risk.
You can gauge the volatility of an investment by examining its price history. For example, if a stock has a tendency to fluctuate considerably over a short time, it is volatile. This is especially the case if the price movements are out of sync with the market. While you might expect stocks to move up and down with general market conditions, a volatile stock will often fluctuate even in times of generally stable markets.
A low-volatility stock will vary in price much less. Its price moves may be more gradual, and it may even move in tandem with a market index most of the time.
Should you be concerned about the volatility of an investment? If you want to assess potential risk before investing for the short term, the answer is yes. If you’re willing to take on more risk to earn potentially higher returns, more volatile investments might be suitable for your portfolio. If you want low volatility, with the tradeoff of lower returns potential, look for lower volatility investments.
You should also be concerned about the overall volatility of your portfolio-in other words, how much the value of your portfolio fluctuates and over what period of time.
This is easily managed by ensuring your portfolio is well diversified. Hold individual investments that vary in their degree of volatility, as well as including all major assets classes in your portfolio. Individual asset classes don’t always move in tandem, and they seldom fluctuate to the same degree at the same time.
You can also reduce volatility worries by focusing on the long-term. With a longer investment horizon, temporary fluctuations don’t matter as much. You reduce volatility risk and take advantage of the fact that over the long-term, the direction of markets is generally up.
You can even take advantage of volatility to enhance returns. If you invest at regular intervals-through a periodic investment plan, for instance-volatility can work in your favor because your regular investment amount will buy more when prices dip. This technique is known as “dollar cost averaging,” and it can lower your cost of investing.
Ask your financial advisor for help in assessing and managing the volatility of your portfolio.
Member Canadian Investor Protection Fund
Jodi Nastor, CFP
390 McNabb Street Unit 2