Nothing strikes fear into the heart of most investors like volatility. However, sudden changes are a normal part of market activity and represent an opportunity for those who understand what the causes are.
Of all the concepts involved in investing, volatility is perhaps the most misunderstood.
This is not surprising given the connotations of the words in other contexts. A ‘volatile person’ is not someone you would be keen to spend a lot of time with and a ’volatile chemical’ is one that needs careful storage. Market Volatility however, is a natural aspect of market behaviour and is actually useful to investors.
Put simply, volatility describes how much and how often the price of an investment changes over time.
If you think about that for a moment, you will realise that without volatility the potential profits from investing would be significantly lower. Without price changes, your returns would be limited to dividends alone, removing the significant gains that are the bedrock of a strong portfolio.
Volatility is often treated as an indicator of risk because without it there is a lower risk of both failure and success.
It can be disconcerting to watch the value of your investments vary over the short term, but the good news is that for the long-term investor, volatility is not a threat.
While every year can have rough patches and market cycles can lead to whole years in which returns are negative, history shows that the overwhelming trend is for the value of investments to increase over the long term.
Fund managers hire strong research teams who work constantly to ensure they have the most up-to-date market and company data.
This enables the Fund Manager to exploit market efficiencies, which can be manifested as volatility, to make active, shorter-term tactical asset allocation decisions, as well as to purchase long-term, more strategic assets at the best price.
The lesson is that while volatility can be disconcerting, it is beneficial to the investment process. If you have any concerns about sudden market movements, you should contact your financial broker.