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Originally published on August 29, 2023, updated with new charts August 15, 2024
Market volatility, meaning the ups and downs of the stock market, can understandably make any investor feel nervous and uncertain. But understanding what market volatility means can help you better navigate a decline. In this post, I'll unlock the mystery behind market volatility and explore its significance for investors.
Understanding Market Volatility
Market volatility refers to the rapid and significant price fluctuations in financial assets, whether it's stocks, bonds, or commodities. It measures the degree of variation in the returns of an asset over a specific period. While market declines are unsettling, they're a natural part of the investment landscape. They're driven by various factors, including economic data, geopolitical events and even investor sentiment (showing that we're all human, after all!)
By understanding market volatility, investors can make more informed decisions and potentially capitalize on opportunities. It allows individuals to assess the risks associated with their investments, adjust their strategies accordingly, and develop a long-term perspective.
Factors That Contribute to Market Volatility
Economic data, such as gross domestic product (GDP) growth, employment figures and inflation rates can heavily influence market volatility.
Farther reaching geopolitical events, such as trade wars, political instability and natural disasters like hurricanes, earthquakes or pandemics, can also contribute to market fluctuations.
Finally, investor sentiment, including fear, greed and market expectations, can play a significant role in market volatility. Fear and panic can lead to selling pressure, causing prices to plummet. Conversely, optimism and exuberance can drive excessive buying, inflating asset prices.
It's important to note that market volatility does not necessarily indicate a negative or positive outcome. While it can lead to potential risks, that's where it can also present opportunities for investors by way of the old adage, "buy low, sell high."
The Impact of Market Volatility on Investments
Market volatility can have both short-term and long-term impacts on investments.
In the short term, market volatility can cause significant fluctuations in the value of investments. This can result in noticeable losses or gains on paper and fluctuate wildly day-to-day, depending on the direction of the market. For short-term traders, market volatility can present opportunities for quick and valuable profits—and big losses.
In the long term, market volatility can affect the overall performance of investment portfolios. High levels of volatility can make it difficult for investors to accurately gauge the value of their investments. This uncertainty can lead to emotional decision-making and potentially harm a portfolio's long-term performance.
It's also important to remember that market volatility isn't synonymous with risk. Risk is the probability of a permanent loss of your invested money, while market volatility is the temporary fluctuation of stock market prices.
Long-term investors who maintain a well-diversified portfolio and adhere to a disciplined investment strategy are better positioned to weather market volatility and potentially benefit from it.
Common Misconceptions About Market Volatility
There are several common misconceptions about market volatility that can lead to poor investment decisions.
One misconception is that market volatility is always a sign of a declining market. While high volatility can indicate uncertainty and potential risks, it does not necessarily mean that markets are in a downward spiral. Volatile markets can also present opportunities for growth and profit.
Another misconception is that market volatility can be accurately predicted and timed. The reality is that market volatility is inherently unpredictable and can occur suddenly.
Attempting to time the market based on volatility is a risky strategy and may result in missed opportunities. I love to remind my clients that it's about time in the market, vs timing the market.
A third misconception is that market volatility affects all investments equally. Different asset classes and individual securities can react differently to market volatility. Some investments may be more resilient and less affected by market fluctuations, while others may be more volatile and susceptible to price swings.
Tips for Managing Emotions During Market Volatility
Market volatility often leads investors to feel strong emotions, like fear, anxiety and greed. These emotions can cloud our judgment and lead to irrational investment decisions.
News headlines about the latest crisis to affect the economy can amplify these feelings and give investors something to worry about. This chart shows how staying invested beyond any current concerns can unlock growth potential in the long-run.
That said, I acknowledge that your emotions are real, so here are some tips for managing them during market volatility.
1. Stay Informed: Keep yourself updated with relevant news and market information so you better understand the factors driving market volatility. Just remember that this big picture view should be tempered by your long-term plan.
2. Maintain a Long-Term Perspective: Remember that investing is a long-term endeavor. Short-term market fluctuations should not overshadow your long-term investment goals.
3. Diversify Your Portfolio: Diversification is a key strategy for managing risk. By spreading your investments across different asset classes and sectors, you can reduce the impact that market volatility has on your portfolio.
4. Have a Plan: Develop a well-thought-out investment plan and stick to it. Taking a disciplined approach even when things feel scary can help you avoid making impulsive decisions based solely on short-term market volatility.
5. Seek Professional Advice: Consider consulting with a financial advisor who can provide
guidance and help you navigate market volatility.
Market Volatility and Long-Term Investing
Market volatility should be viewed through the lens of long-term investing. History has shown that markets have a tendency to recover from downturns and deliver positive returns over the long run. By staying invested and maintaining a long-term perspective, investors can potentially benefit from market volatility.
Let's take into consideration the history of the S&P 500 since 1928:
94% of years experience a decline of 5% or worse
64% of years experience a decline of 10% or worse
40% of years experience a decline of 15% or worse
26% of years experience a decline of 20% or worse
The below chart from J.P. Morgan which they update every quarter shows declines in the S&P 500 during the year, versus the annual returns by end of year. While the S&P 500 has an average maximum decline of 14%, in most years it's recovered those losses to finish the year higher.
Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management.
Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2023, over which time period the average annual return was 10.3%.
Another popular measure of this is that the S&P 500 had positive returns for more than 75% of the annual periods from 1926 to the present. This increases to 88% if you look at all rolling five-year periods and 94% of rolling ten-year periods.
Also, the longer-term returns after the worst years in the market have historically been strong with the average three-year historical return at 35% and the average five-year return at 80%, as shown in the chart below.
In fact, market volatility can actually present buying opportunities for long-term investors. During periods of market downturns, prices of quality investments may become undervalued, providing an opportunity to acquire those assets at a lower cost. This can potentially lead to higher returns when markets eventually recover.
Power Through Market Volatility
Market volatility is a natural part of the investment landscape. Understanding what market volatility really means can help investors to make informed decisions when it comes to navigating the ups and downs of the market. If you're feeling uncertain and you have one, it's best to review your financial plan before you review your portfolio.
By recognizing the factors that contribute to market volatility, managing emotions, and maintaining a long-term perspective, investors can potentially benefit from market volatility and achieve their investment goals.
For more tips like these, download my free ebook series that covers debt management, growing your income to save more, investing wisely and planning to make work optional. To learn what it's like to work with a financial advisor, you can book a free call with Life Story Financial.
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