Who's afraid of big bad volatility?

Share prices suddenly plummet. Interest rates are rising. Housing prices falling. Commodity prices at peaks. The headlines are painting a volatile picture of markets at the moment. Volatility suggests a world of pain for investors – no one likes to see their portfolios shed a massive volume in a short period. It doesn’t always mean pain though. Volatility is a normal part of the investment journey and can even be a good thing (yes really!)

What is volatility?

Volatility is price movement in asset prices and generally refers to sharp upwards or downwards movements.

It relates to sensitivity to a range of activities and events, ranging from cash rate changes, political activity, investor mood, or even weather events like flooding.

Volatility is generally measured by standard deviation of average prices. A lower number indicates a less volatile asset, while a higher number indicates a more volatile asset.

It can also be measured using options prices. A bit like looking at betting odds. If prices are rapidly changing between short and long options (that is, expecting value to fall v rise) in a short period of time, you might say that the market is more volatile.

While you can measure the volatility of individual assets or stocks, there are also indices to measure broader segments of the market. One of the most commonly cited measures of volatility is the CBOE Volatility Index (CBOE: VIX) which measures the magnitude of movements in the S&P500. It uses options prices to determine its value. You can see the one chart of the VIX index below.

CBOE Volatility Index (VIX) prices to 23 September 2022

There have been some sharp jumps and falls in there – but the trend across the last month has been towards growing volatility.

Riding the rollercoaster

It doesn’t matter what your investment portfolio looks like, at some point, you will experience volatility – it’s just a fact of life.

Some asset types are more prone to volatility than others – and the levels of volatility can vary within asset classes too.

One example is that shares are usually more volatile than bonds or cash.

Looking closer at the variation within shares:

• Shares from emerging market countries tend to be more volatile than those from developed markets. This can reflect the more dynamic geopolitical situations in these countries.
• Shares in technology companies tend to be more volatile than shares in consumer staples. People still need to buy groceries in tough times, whereas they may be happy to cut back on new innovative technology purchases. Tech stocks are also, by their nature, long duration - so an increase in bond yields (especially at the long end of the curve) doesn't do their valuations any favours.
• Within sectors, there can be differences in companies depending on how established they are. For example, CSL (ASX: CSL) might be less volatile than Telix (ASX: TLX) because CSL has more established products and pipeline, while Telix is still building out.

Strapping on a safety harness, or how to manage volatility in your portfolio

Portfolio construction is a vital part of riding out volatility – and even benefiting from it. It comes back to that old chestnut – diversification, diversification, diversification.

Typically all your assets won’t be volatile at the same time – because different assets perform differently. What drives volatility in one asset, might not cause the same problem in another. So considering the correlation between asset classes when you build out your portfolio and balancing your assets can help periods like the current one.

You can see performance correlations of different asset classes in the chart from Morningstar below.

Correlation matrix for 14 asset classes

The closer to 1.000 two assets are, the more closely their performance is linked.

For example, US Large cap growth shares have a correlation of 0.848 with US large cap value shares which means their performance will be fairly similar at this point. By contrast, US large-cap growth shares have a correlation of 0.005 with non-US bonds which means their performance isn’t linked and the same market events are less likely to cause both assets to fall or rise at the same time.

You want a nice blend of different assets with varying correlations and selected to fit your overall investment philosophy and strategy. Read more about setting an investment philosophy and strategy here:

Education

Why a solid philosophy and strategy will make you a better investor

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This doesn’t mean you won’t see those sharp dives and climbs, but you’ll be better positioned to withstand them. And who knows, maybe one asset class will offset the volatility in another.

Cool heads prevail – a few tips when volatility strikes

It’s normal to feel stressed and upset when you see the value of your portfolio dropping. Now is not the time for rash decisions.

Selling out of the market crystallises any losses in your portfolio. If your portfolio is well constructed with solid investments, then you are best riding out the wave until sunnier markets.

It’s also worth remembering that there could be opportunities in the volatility so have some cash on hand. That same cash could also be a buffer against having to sell down your portfolio in downturns if you face any unexpected emergencies.

For example, value investors love volatile markets because they might be able to access solid companies that are undervalued. Had your eye on a particular company and thought it was too expensive previously? You never know, now could be your moment to invest.

There are a few things you can do when volatility hits – and ideally after a solid night’s sleep and a coffee.

1. Reflect and assess: revisit your strategy and assess your investments’ merits in their own right. Do your investments still fit your strategy? Are the fundamentals still solid despite market noise? This can be a reassuring step if you’ve been worried.
2. Cut your losses if you have to: if your strategy and portfolio really aren’t fitting your needs and objectives, seek help with realigning it. It doesn’t have to be an all-or-nothing approach – you may find you can adjust a bit at a time to minimise any losses. From an individual stock perspective, if a stock has poor fundamentals and there’s no chance for redemption, it may be better to sell out and take the hit. Invest where you can in high-quality companies, and it will position you better in the long term.
3. Take opportunities where you can: if that blue-chip you’ve been eyeing off is looking undervalued, now could be your opportunity. Be selective and keep to your strategy when you buy in volatile periods.

Final words of wisdom

Volatility is all part and parcel of being an investor – albeit sometimes a stressful part. Volatility is not a constant though and it won’t always be negative, sometimes it will be in your favour.

The current market environment is causing a lot of concern globally. If we are heading towards a recession, it’s worth heeding these words of advice from industry stalwart Dr Philipp Hofflin:

“Recessions still happen but they always end, you invest for the long term.”

In fact, they typically only last 18 months – significantly shorter than the average bull market. You can read more in this article:

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Geoff Wilson and Philipp Hofflin share three lessons from investing in a recession

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Will you be looking for buying opportunities in the current volatility? Let us know in the comments what companies you have your eyes on.

Frequently asked questions

What is market volatility?
Volatility is price movement in asset prices and generally refers to sharp upwards or downwards movements.

How is volatility measured?
Volatility is typically measured by standard deviation of prices. It can also be measured by options prices.

How can I manage volatility in my portfolio?
You can help manage volatility using careful portfolio construction according to your investment strategy. Diversification is a key measure as different assets perform differently in different environments and may not be affected by volatility at the same time or in the same way.