Understanding Volatility: What It Means and How to Manage It
Volatility refers to the pace at which prices move higher or lower and how wildly they swing. While you can look at the price of just about anything, stock market analysts often examine an average of the many companies listed on a market, such as the Dow Jones Industrial Average (DJIA) or the Toronto Stock Exchange (TSX) Composite. But what exactly does volatility mean for you as an investor? Let’s dive into this critical topic and unpack how understanding volatility can protect your investments and your peace of mind.
What Is Market Volatility?
In simple terms, market volatility measures how much and how quickly the price of assets rises or falls over a period of time. High volatility means dramatic price changes, while low volatility suggests more stable, predictable price movements. For example, during the calm period from 2009 to early 2020, the stock market experienced relatively low volatility. By contrast, the early months of the COVID-19 pandemic in 2020 saw unprecedented swings, with record-setting gains and losses in single trading days.
Why Is Volatility Important?
Volatility affects everything from your investment strategy to your emotional well-being. For most investors, low volatility feels like a safe and steady climb toward financial goals. However, high volatility can trigger fear and panic, leading to impulsive decisions like selling off investments during a downturn. Understanding volatility helps you stay grounded and avoid costly mistakes.
The Connection Between Market Volatility and Emotional Volatility
It’s easy to think of market volatility as a purely financial concept, but it has a strong emotional component. When markets are calm, we tend to become complacent, believing the good times will last forever. This mindset often leads to higher spending, increased debt, and a lack of emergency savings.
On the other hand, high volatility creates uncertainty and fear. Imagine seeing your investments lose 30% of their value in a matter of weeks. The instinct to cut losses and sell is powerful, but it often results in locking in losses rather than waiting for a recovery. The key to managing volatility lies in understanding and controlling your emotional responses.
How to Stay Calm During High Volatility
1. Have a Long-Term Perspective
Market downturns are temporary, but long-term growth tends to prevail. For example, the global financial crisis of 2008 was followed by over a decade of strong market performance. Keeping a long-term outlook can help you avoid knee-jerk reactions during volatile times.
2. Diversify Your Investments
Diversification is a proven strategy to reduce risk. By spreading your investments across different asset classes, sectors, and geographies, you can cushion the impact of market swings. For Canadian investors, this might include a mix of domestic stocks, international equities, bonds, and even real estate investment trusts (REITs).
3. Build an Emergency Fund
Having three to six months’ worth of expenses saved in an easily accessible account can provide a financial safety net during periods of high volatility. This reduces the need to dip into investments when markets are down.
Lessons from the March 2020 Crash
March 2020 was a case study in extreme market volatility. The DJIA recorded its five largest daily gains and losses in the same month, reflecting the uncertainty surrounding the global pandemic. However, markets eventually recovered, and many who stayed invested saw their portfolios bounce back.
Key Takeaways from 2020
1. Emotional Discipline Is Crucial
Investors who resisted the urge to sell during the 2020 downturn often benefited from the recovery. This highlights the importance of staying calm and sticking to your investment plan.
2. Preparation Matters
Periods of low volatility are the perfect time to prepare for future market swings. Review your financial plan, rebalance your portfolio, and ensure you have an adequate emergency fund.
Practical Steps to Navigate Volatility
Here are some actionable strategies to help you manage market volatility:
1. Regularly Review Your Investment Portfolio
Check your asset allocation to ensure it aligns with your risk tolerance and financial goals. Rebalancing your portfolio can help maintain the desired level of risk.
2. Automate Your Investments
Setting up automatic contributions to your investment accounts helps you stay consistent, even during turbulent times. This strategy, known as dollar-cost averaging, reduces the impact of market fluctuations over time.
3. Stay Informed but Avoid Overreacting
While it’s essential to stay updated on market trends, avoid the temptation to make frequent changes based on short-term news. Focus on credible sources and long-term data.
Resources for Canadian Investors
Canadian investors have access to a range of tools and resources to manage volatility:
- Financial Consumer Agency of Canada: Offers financial literacy resources and tools.
- RBC NOMI: A budgeting and savings app for RBC clients.
- Qtrade Direct Investing: A Canadian platform for self-directed investors.
- Manage Your Money: Comprehensive financial advice and resources.
- Wealthsimple: Investment tools and robo-advisor services.
- Investopedia: In-depth articles on investment strategies and market concepts.
Conclusion
Volatility is an inevitable part of investing, but understanding it can help you navigate the ups and downs with confidence. By preparing during calm periods, staying disciplined during turbulent times, and using the tools and strategies outlined here, you can build a resilient investment plan that withstands market swings.
Remember, the key to success is not to avoid volatility but to manage it wisely. Stay informed, stay calm, and stay invested!
In my E-books (“Water Barrel” and “The Balance”) I discuss simple methods to live sensibly for today, take charge of your financial affairs, and invest safely for the long term. For more information please visit David Penna Amazon.
Disclaimer for ManageYourMoney.ca
The information provided on ManageYourMoney.ca is intended for educational and informational purposes only. It should not be taken as financial advice. The opinions shared are those of the authors and are meant to encourage sensible financial habits and decision-making. We recommend that you do your own research or consult a certified financial advisor before making any financial or investment decisions. All investments come with risks, and there is no guarantee of success. Past performance is not a reliable indicator of future results. Always consider your personal financial situation and risk tolerance before pursuing any investment opportunities.
As always, we are not a qualified financial advisors. We just relate financial management to our own experience which may not resemble yours at all. Advice is frequently worth exactly what you paid for it. Most of ours came from expensive experiences. Neither Jim nor David provide advice on any specific investments.
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