By: Dr. Jeff Jones
Volatility reflects the uncertainty of a particular outcome. In the world of investments, volatility reflects the risk of an investment. The risk of an investment is the fluctuations in price that occur over time and is generally measured by something called standard deviation. People often misconstrue risk as the chance of only a bad outcome occurring. However, risk reflects the possibility of something good or bad happening. Assuming risk is what provides investors the opportunity to earn higher returns.
Volatility is also closely related to the expected, or required, return on an investment. If an investment has more risk, then investors will demand a higher return for that investment. Rational investors will not bear risk without the expectation of a higher reward.
There are two key aspects to managing and surviving the overall volatility of financial markets: diversification and liquidity. Diversification involves investing in a variety of assets, particularly those types of assets whose prices are not highly positively correlated. Correlation is measured on a scale from -1 to +1. Assets that have a correlation of +1 move perfectly together in the same direction. Assets with a correlation of -1 move in exactly opposite directions, and assets with a correlation near 0 are considered to be uncorrelated.
Despite the best efforts of investors to achieve a well-diversified portfolio, it is virtually impossible to eliminate all risk, with the exception of investing exclusively in cash (a very low return investment). Even in seemingly well-diversified portfolios, big problems can still occur when the typical historical correlations between asset classes break down. For example, historically the average correlation between stock and bond prices is quite low, and even negatively correlated in many years. This would indicate that holding both stocks and bonds in a portfolio might provide substantial diversification benefits. However, during periods of extreme financial stress, stocks and bonds can be highly positively correlated over short periods of time, in which case the benefits of diversification are considerably diminished. History has shown us time and again, however, that such correlation breakdowns tend to be short lived. When they occur, avoiding panic and focusing on the long-run are the most profitable strategy for investors.
Perhaps more important than the diversification of the portfolio is to understand the liquidity needs of your portfolio, an often overlooked aspect to surviving a period of financial market volatility. For example, if you are 35 years old and your portfolio consists mostly of retirement-related assets from which you currently (or in the near future) will not depend on receiving income, your liquidity needs from the portfolio are quite low. If you are 65 years old and are approaching or in retirement and expect to begin relying on your portfolio for income, your liquidity needs are likely quite high. In the latter situation, holding a larger portion of the portfolio in cash (say 1-2 years of expected required income) will afford you the opportunity to avoid selling assets at depressed prices during a potential market downturn in order to satisfy your income needs.
Regardless of your age or financial situation, it is important to understand the potential impacts of financial market volatility on the value of your investment portfolio. For more information on developing an investment portfolio that is well diversified and sufficiently liquid for your intended needs, consult a financial advisor.
This article appeared in the October 31 edition of the Springfield News-Leader and can be accessed online here.
Dr. Jeff Jones, CFA®, CFP®, CPA, CMA, CFM is an Assistant Professor of Finance at Missouri State University. The views expressed in this article reflect those of the author, have been distributed for educational and informational purposes only, and should not be construed as investment advice or a recommendation of any specific security, strategy, or investment product.