How we feel about investment risk is often tied to how we feel about volatility. Even though the two, risk and volatility, 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.
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 smaller or larger the volatility, the smaller or larger 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 5% and a one year standard deviation of 5%, we anticipate that in any given year that investment will have a range of potential returns of 0% to 10%. 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 be smoothed over time. The markets reward patient investors who stay the course.
What causes it?
It would be wonderful if there was a single cause of volatility, but that is 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. We can break it 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 is 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.
For every person selling an investment due to their 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 naturally more stable, like consumer staples. The good news is that volatility is smoothed considerably over time.
Why is it 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. We can see an example of this when selling a house. If we only have one interested buyer, we have to either accept the price of the offer, or we take the house off the market. When there are multiple buyers, the price can be driven up or we have a better chance of getting the price we want.
What does it all mean in the end?
When stock prices fall, it is normal to have feelings of unease or concern. It is difficult for anyone to watch the value of their investment(s) decrease. It is important to take a step back and refer back to your financial plan when this happens. A plan helps you to stay invested, even though the turbulence your investment portfolio is experiencing seems otherwise.
The charts below depicts the marked difference between the short and long term volatility for a typical investment. Markets reward the patient investor.
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.
We can manage volatility through diversification. If your entire portfolio is invested in one single investment, sustaining a drop in value can be permanent, and the results could be catastrophic. At the portfolio level, we endeavour to manage volatility and risk through diversification across asset classes, investment styles, sectors, company sizes and geographic areas. Diversification enables us to stay the course, regardless of the daily or weekly price volatility our portfolio experiences.
This report has been prepared by ATB Investment Management Inc. (“ATBIM”) which manages the Compass Portfolio and ATBIS Pools. ATBSI is a member of the Investment Industry Regulatory Organization of Canada (IIROC) and the Canadian Investor Protection Fund (CIPF). ATBIM, ATB Securities Inc. (“ATBSI”), and ATB Insurance Advisors Inc. are wholly owned subsidiaries of ATB Financial and operate under the trade name ATB Wealth.
The mutual fund performance data provided assumes reinvestment of distributions only and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any security holder that may reduce returns. Unit values of mutual funds will fluctuate and past performance may not be repeated. Mutual Funds are not insured by the Canada Deposit Insurance Corporation, nor guaranteed by ATBIM, ATBSI, ATB Financial, the province of Alberta, any other government or any government agency. Commissions, trailing commissions, management fees, and expenses may all be associated with mutual fund investments. Read the fund offering documents provided before investing. The Compass Portfolio and ATBIS Pools includes investments in other mutual funds. Information on these mutual funds, including the prospectus, is available on the internet at www.sedar.com.
Opinions, estimates, and projections contained herein are subject to change without notice and ATBIM does not undertake to provide updated information should a change occur. This information has been compiled or arrived at from sources believed reliable but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. ATB Financial, ATBIM and ATBSI do not accept any liability whatsoever for any losses arising from the use of this report or its contents.
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