Don't fear volatility

How we feel about investment risk is often tied to how we feel about volatility, even though they mean different things. In theory, the amount that an investment’s price moves up and down is volatility, while risk is the permanent loss of capital, which is what most people actually fear. The framing of both, often by cold, hard metrics, may sway investors to fear volatility, even though it might not always be negative. Sometimes, volatility can be a good thing for a long-term investor. Let's explore why.

What is volatility?

Checking your weather app before leaving the house helps you plan for your day. It can help you dress appropriately and to bring an umbrella in case there’s rain. The complexity of our weather system makes it hard to predict over longer time frames, with a greater chance that the actual weather will change from what was originally predicted. Temperature one day to the next can change dramatically, but over time average highs and lows as well as average number of days of rain can be determined. However, as all Albertans know, temperature often falls outside of averages, and even outside the expected range of temperatures. Stock market volatility is similar as it measures fluctuations in stock prices. The greater the volatility, the greater the fluctuation in prices.

Volatility is commonly expressed as standard deviation, which is a statistical term that measures dispersion around an average. If an investment has an average return of 10%, and a one-year standard deviation of 5%, we anticipate that every 9 years out of 10, that investment will have a potential return of 0% to 20%. However, even though that is the range we would expect to see, markets are unpredictable and returns could fall outside that range over the short term. The chart below shows that the range of returns for the S&P/TSX Composite Index was considerably wider for the one-year period versus the range for a five-year period. This result is expected, because the impact of volatility tends to flatten over time. The stock market rewards patient investors.

S&P/TSX annualized total return ranges

Source: Bloomberg - Range of data used, January 1956 to January 2022

What causes volatility?

It would be helpful if there was a single cause of volatility, but that’s not the case. Investment products listed on public exchanges are priced daily, which means prices can fluctuate on the same basis. Some products have more pronounced moves than others. Volatility is actually a very broad classification and can be broken down into several categories, including market volatility (when the entire market is facing price movements), geographic volatility, sector volatility and single stock or bond volatility. Regardless of how you categorize it, volatility occurs as a result of multiple factors.

A negative story can cause temporary drops in stock prices. Whether it’s a news story published in a major newspaper or a social media post by an influential or political figure, each of these events can impact daily price fluctuations.

Source: ATB Wealth

For every person selling an investment due to personal concerns, there is a buyer on the other side of the trade who sees a growth opportunity. Sometimes volatility can be fleeting, lasting only a few hours, and sometimes it is much more sustained, lasting several months. Some sectors are naturally more volatile, like energy, while others are more stable, like consumer staples.

Why volatility can be a good thing

Volatility helps to regulate the stock and bond markets. It can help lift the prices of depressed stocks and bonds, while also bringing prices back down after they sky rocket to new highs. This is often referred to as price discovery in the stock and bond markets. Price discovery is the process of buyers and sellers settling on the price of an individual security. If there are too many sellers, causing too much supply on the market, the price will typically fall. When we have too many buyers, or demand is high, the prices will be driven up. Look at real estate, for example. If a seller only has one interested buyer, they have to either accept the price of the offer, or take the house off the market. When there are multiple buyers, the price can be driven up.

What does it all mean in the end?

When stock prices fall, it’s normal to have feelings of unease or concern. It’s difficult for anyone to watch the value of their investment(s) decrease. It is important to take a step back and refer to your financial plan when this happens. A plan helps you to stay invested, even though the turbulence your investment portfolio is experiencing suggests otherwise.

Volatility is a natural part of a healthy stock market. Lower prices can provide opportunities to build or grow your portfolio at a lower cost. This can add up to significant wealth over time — if we have the patience and discipline to stay invested during market downturns.

ATB Investment Management Inc. can manage volatility through diversification. If your entire portfolio is sunk into a single investment, sustaining a drop in value can be permanent with detrimental long-term results. At the portfolio level, we endeavor to manage volatility and risk through diversification across asset classes, investment styles, sectors, company sizes and geographic areas. Diversification enables us to build robust portfolios built for long-term success, regardless of the daily or weekly price volatility our portfolio experiences.