Volatility refers to the rate of change in the price or value of an asset, security or market over a given period, usually measured by the standard deviation or variance of returns. It reflects the level of risk or uncertainty associated with the price movement of an asset. High volatility indicates large price fluctuations, while low volatility suggests more stable prices. Managing volatility is an important consideration for all investors, but especially for those approaching retirement age.
A wide range of fundamental factors can cause volatility, ranging from economic conditions to earnings reports. And while market volatility may cause investors to pause before entering or exiting a position, there are many investment strategies that benefit from fast short-term price movements. Volatility is not inherently positive or negative, and there are ways to limit the impact of volatility on your portfolio.
Keep reading to learn more about how understanding your risk tolerance, diversifying your portfolio, and implementing effective strategies can help you confidently navigate and manage market volatility.
Understand your risk tolerance and goals
How much volatility is too much? The answer will depend on your unique risk tolerance, that is, your comfort level with placing money in the markets. Volatility is generally linked to risk and return, meaning your financial goals will play a major role in the ideal volatility of your portfolio.
For example, if you’re a young investor, you’ll likely have decades left in the market to accumulate wealth. This means your risk tolerance is higher than that of an older investor approaching retirement. Determining your investment goals, using a risk questionnaire or consulting with a financial advisor can help you determine your risk tolerance.
Key strategies for managing volatility
Anticipating and managing portfolio volatility becomes increasingly important as you get closer to achieving your financial goals. Use these strategies to incorporate volatility into your investment portfolio at a level that suits your risk tolerance.
Diversify your portfolio
A diversified portfolio helps mitigate the impact of volatility by spreading investments across different asset classes and companies, with each class representing a different level of volatility. For example, growth stocks such as technology stocks tend to experience greater volatility than consumer staples stocks due to their cyclical nature. Younger investors with a higher risk tolerance may want to shift assets toward growth stocks while maintaining a basket of stable assets to reduce their overall risk of loss.
Allocate assets strategically
Strategic asset allocation involves tailoring your portfolio to suit your risk tolerance and financial goals, and reallocating assets as your needs change. For example, stocks tend to be more volatile than bonds because they lack financial guarantees from issuers. If you want to control volatility, you can invest a larger percentage of assets in stable classes such as bonds and real estate.
Protect yourself
An easy way to ensure stability in your portfolio is to invest in a defensive exchange-traded fund (ETF). ETFs hold a series of stocks divided among all investors who own shares of the fund, providing instant diversification to your portfolio without having to research individual companies. An example of a defensive ETF is the Invesco S&P 500 Low Volatility ETF (NYSEARCA: SPLV)., an S&P 500 index fund focused on less volatile companies.
Secure your risk
“Market hedging” is an investment strategy involving asset classes that traditionally produce returns when the overall market declines. Examples include put options and inverse ETFs, which are designed to mirror the opposite movements of major indexes. While these assets can be useful during periods of economic stress, they tend to perform poorly when the market is doing well and should be used with caution.
Focus on your long-term goals
Short-term market fluctuations are common, but over time, a well-diversified portfolio can smooth out these ups and downs with stable growth. Historically, markets have demonstrated resilience, with diversified portfolios often recovering from downturns and delivering positive returns over long periods of time.
By avoiding the need to react to daily market fluctuations, you keep your portfolio aligned with your ultimate financial goals rather than being affected by temporary market movements. An impulsive reaction to short-term volatility can lead to costly decisions such as selling low or missing the subsequent recovery. Review your portfolio only as often as you need to, and resist the temptation to sell impulsively.
Common mistakes to avoid in volatile markets
Volatile markets are notoriously difficult to manage, especially if you regularly review your portfolio. Avoid these three common mistakes to achieve greater profits over time.
1. Panic selling
During periods of market uncertainty, investors often panic and sell investments at a loss, believing that prices will continue to fall indefinitely. Historically, markets have recovered from declines in all major sectors. Panic selling locks in your losses, preventing you from benefiting from a market recovery. Stay calm, focus on long-term goals, and avoid making investment decisions based on fear, especially during periods of high volatility.
2. Trying to time the market
Investors who “time the market” attempt to strategically invest when the market is low with the intention of selling when prices rise. While this strategy seems like a good idea, most investors fail to accurately predict price movements, leading to missed opportunities and compounded losses. Dollar-cost averaging, which involves making consistent purchases over time, usually leads to better long-term results.
3. Overreacting to news
Reacting to market news or financial headlines can lead to impulsive decisions that cause you to enter or exit positions without considering the full consequences of doing so. For example, if you read negative headlines about a stock and decide to sell it, you may have to pay higher taxes if you haven’t held the asset for a year or more.
How to remain resilient in a volatile market
While market volatility is an integral part of investing, it should not interfere with your financial goals. By understanding your risk tolerance, diversifying your portfolio, strategically allocating assets, and focusing on long-term goals, you can mitigate the impact of volatility and make more informed investment decisions. Avoid common mistakes and maintain a steady and disciplined approach to your portfolio. With careful planning and a focus on your financial goals, you can confidently navigate market fluctuations and set yourself up for long-term success.
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