How financial market volatility can impact investments

Managing volatility is all about managing your exposure to risk. If an investment or market is considered to have a low level of volatility, it typically indicates that its price tends to be relatively steady over time.

However, if it’s viewed as volatile, it means that its value can fluctuate dramatically over short periods.

Ultimately the greater the potential volatility of an investment, the riskier it is. But equally more volatile investments typically have the potential to deliver higher returns than less volatile assets. For example, US government bonds would usually be viewed as low volatility compared to equities but while shares are viewed as higher risk, they also tend to have the potential to deliver higher returns.

Numerous factors can influence asset prices, but sharp peaks and troughs tend to be caused by some significant event - or series of events. Below we outline some of the main causes of volatility.

  • Political uncertainty

Political uncertainty has the potential to be a major driver of market volatility. For example, if a country has a change of government and as a result, investors are concerned that new policies or taxes would negatively affect companies or markets, they may decide to sell investments in a hurry which could send markets tumbling. Equally, political change could cause markets to rise if an incoming administration is considered to be investment-friendly.

  • Economic data

Economic indicators can help investors understand the health of an economy, such measures include Gross Domestic Product (GDP) – i.e. economic growth, or employment numbers and Purchasing Managers’ Indices (PMIs) which reflect activity in the manufacturing and services sectors. When such data experiences a strong swing, for better, or worse, financial markets tend to react accordingly.

  • Monetary policy

Changes in monetary policy such as a rise or fall in interest rates - or even the expectation of such changes - can and do impact markets.  For instance, if the head of a country’s central bank says they may look to increase interest rates in future, investors know that this could increase borrowing costs for businesses, which may have a negative impact on market sentiment.

  • Sector biases

If investors get spooked and feel that investing in a particular industry, or industries, is no longer a good idea, they might decide to sell. For instance volatility can be caused by sudden or sustained excitement around the future prospects of a sector. Take the ‘dot com bubble’ of the late 1990s when the value of many internet-based companies soared only to subsequently fall when the bubble burst at the turn of the century.

  • Unforeseen events

Unforeseen occurrences, such as natural disasters like an earthquake, can impact stock and bond markets. As well as the loss of life and costly damage to infrastructure, natural disasters can disrupt the business activity of large areas - with a knock-on effect on trading partners - causing significant setbacks in economic terms.

Why volatility matters

When it comes to investing, the real issue regarding market volatility is not just about losing money but the effort required to regain your losses if you do take a hit. To put this in context, if your portfolio lost 50% of its value, this means it would subsequently need to achieve a 100% gain just to get back to where it started.

For those thinking long-term and investing regularly, volatility can be a potential advantage. By drip-feeding money into the market, it means investors potentially benefit from ‘pound-cost averaging’, which helps to smooth out investment returns over time, as investors purchase more shares when prices are low, and less when they are expensive.

Therefore, over time, you’ll end up paying the average price during that period, which should help ease the influence of market volatility over the long term.

How can you manage volatility in your investment portfolio?

The best way to tackle market volatility is to be prepared for it. This means taking an active approach and maintaining a well-diversified portfolio, where your money is spread across a wide variety of different investments including cash, bonds, equites and property.

It also means taking a long-term view. For investors volatility can of course be unnerving, but markets can endure troubled periods. But difficult as it might be, sitting tight and doing nothing can often be the best course of action when markets turn turbulent.

For instance - and bearing in mind that past performance is not a guide to future returns - if an investor had put $1,000 into the MSCI World Index 40 years ago, they would since have witnessed their lump sum grow to $34,527. But if they’d missed just five of the best days over that term, they would have been left with a far lower $24,060[1].

As such, getting spooked and cashing out when trouble rears its head could potentially mean lower returns in the long run. Equally there is no guarantee that your investment will bounce back if it falls in value as a result of market volatility.

 

[1] Source: Bloomberg, Datastream and AXA-IM Research; Note: All calculations done using MSCI indices over the last 40 years ending December 2018. Performance based on reinvestment of dividends.