Daniel Lee

Nov 26, 20218 min read

Volatility Explained: Should You Be Afraid Of It

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Introduction

In this video, we will explore the concept of volatility mainly

What volatility is and how do we measure it
What causes volatility
The expected volatility of the different asset classes
Is volatility good or bad for investors
How do we deal with volatility

1. What is volatility & how to measure it

Volatility is an up and down movement of the price of the investment.

When we say something has high volatility, what we mean is that the prices of the investment move up or down drastically.

Conversely, when we say something has low volatility, what we mean is that the prices of the investment do not move up or down too much.

How then can we measure volatility?

In statistical terms, volatility is measured and represented by the standard deviation (a.k.a. the amount of variation) of the investment’s annualised returns over a given period.

You can often find this information online or in the fund fact sheets.

2. What causes volatility

As prices are determined by the demand and supply of the given investment.

Volatility is essentially caused by the very changes in the demand and supply of the investment which is sensitive to things like

political and economic factors
industry and sector factors
individual company’s performances

As new information is presented to the market, it affects the desirability of certain investments causing the investors to demand and supply to shift.

When that happens, prices will move up and down accordingly depending on which side is stronger,

If there is more demand than there are in supply, prices will be pushed up.

If there is more supply than there are in demand, prices will be pushed down.

That is the main cause of volatility that we experience in our investments on a day to day basis

3. Expected volatility of different assets class

So, what’s the volatility and return of the different asset classes?

Courtesy of visual capitalist, what you’re looking at here is the return of the different asset classes from 1985 to 2020.

From this chart itself, you will realize that the saying high-risk high-reward is somewhat true if the risk, in this case, refers to the volatility of the investment.

The reason why the volatility level of emerging marking stocks or small-cap stocks is higher than say Developed market or large-cap stocks is because these stocks are often companies or countries that are still developing.

Because of the nature of developing things in general, you can expect these developing regions, countries, industries or companies to experience more hiccups and setbacks as compared to things that are already developed.

You can also expect the returns of things that are developing to be higher than things that are already developed because the growth potential is higher in things that have more room to grow as compared to things that are already fully developed.

Just as children and teenagers grow taller and bigger yearly before they become adults and stop growing, companies, industries and countries will also experience a certain level of growth while progressing from a developing to a developed class.

As a result, during this growing phase, you can expect the returns to be higher but also the volatility to be higher just as children and teenagers experience their fair share of emotional volatility when they are growing.

4. Is volatility good or bad for investors?

Volatility, if not managed properly, is bad for investors.

It doesn’t matter whether you are investing for the short-run or the long run, volatility can be destructive to your wealth if you do not deal with or manage it properly.

Here’s why:

4.1 Volatility causes emotionally driven decisions

Emotionally, volatility can lead to very bad investment decisions that you know is not rational and that it is bad for your investment performance. Let me explain, and as I explain I want you to parallel with your own experiences or the experiences of others that you have seen.

When a stock experiences a high level of upside volatility and provided decent returns in a short period, it becomes a hot topic that a lot of people – investors or non-investors – would strike a conversation about it.

When that happens, it creates curiosity among those who aren’t investing and it creates greed among all participants. The thought of: “what if I am missing out on this opportunity of a lifetime”.

Ultimately, this will result in people buying into an investment at high and higher valuations without considering whether the price movement is sustainable or the risk level that they are taking on at that current price level.

Conversely, when a stock experiences a high level of downside volatility causing large losses in a short period, people who are invested will begin to experience some form of fear or panic – regardless of whether or not they make a loss on their investments.

When that happens, people who are invested will be thinking to themselves: “should I sell off my investments to avoid the price fall and buy back in again after the price has dipped” despite knowing fully that it is impossible to time the market.

Ultimately, this will result in people selling their investments to try and avoid losses by attempting to time the market.

Often, this emotional side of our minds speaks louder than the rational side of our minds. It doesn’t matter how rational you think you are; you will have such thoughts when you experience any form of upside or downside volatility.

Of course, if you are a seasonal investor, you will learn to appreciate the fact that we are all irrational beings and from there you can take actions to prevent acting on your irrational thoughts.

However, most investors who are new or inexperienced, often fall into the trap of thinking that what they are doing is driven by rational factors when in fact they are rationalizing their irrational thoughts.

That is why, emotionally, volatility can lead to very bad investment decisions regardless of how rational or smart you think you are.

4.2 The impact of volatility Drag

Mathematically, volatility causes this thing called volatility drag which is often overlooked by people who buy and forget in the name of long-term investing.

To put it simply, volatility drag is the phenomenon of what goes down does not fully go up and it happens because mathematically a percentage of return is not the same as a percentage of losses.

Think about it, if your investments suffered a 50% loss and the price went from $100 to $50. How much percentage returns do you think you will need to break even on your losses?

The answer is 100%. You will need a 100% return on your investment to cover a 50% loss that you’ve suffered previously.

As a result, a percentage in return is not the same as a percentage in losses. In fact, losses have a higher impact on your wealth as compared to profits.

Let me explain using an illustration

Assuming that I have 3 hypothetical scenarios below.

Source: Farmtogether: Why Volatility Can Be Bad For Long Term Returns

Scenario A has the lowest volatility. In any given year, it never grows by more than 10% or loses more than 5% of its value.

Scenario B is somewhere in the middle in terms of volatility. In any given year, it never grows by more than 25% or loses more than 20% of its value.

Scenario C has the highest volatility. In any given year, it never grows by more than 40% or loses more than 35% of its value.

What you will realize from this is that scenario A, the one with the lowest return and volatility performed than scenario C, which is the one with the highest return and volatility.

It is quite counter-intuitive but that’s just how percentages and math work.

You need to understand this concept and manage your downside risks to avoid suffering high levels of losses instead of turning a blind eye to your investments and fooling yourself that everything is okay because you are investing long term.

Managing your risk is very different from attempting to time the market.

5. How can you deal with volatility

When it comes to managing and dealing with volatility, there are a few active steps you MUST take to ensure that you are in control of your emotions and also in control of your risk management.

Let us go through them one at a time

5.1 Plan & Position yourself financially

The first is to position yourself to be able to take a punch from the market. You need to plan your finances in a way whereby you are not at the mercy of market volatility when it comes to financing for your lifestyle and also financing for your short-term plans.

In other words, you should plan your finances in a way where you are not forced to withdraw your investment simply because you need it to pay for things that are due within 5 years.

The last thing you want is to be forced to withdraw your investments at the worst possible time just because you need the money to pay for your renovation or to pay for your parent's medical expenses.

5.2 Dollar Cost Average to avoid market timing

To reduce the impact that volatility has on your investments, what you can do is implement your investments via a dollar-cost averaging approach.

Long story short, don’t try to time the market, history has shown that it is impossible to time the market. In fact, it is easier to predict the weather than to predict the price movement tomorrow.

The dollar-cost average will help you eliminate the risk of buying at the wrong price and also reduce the impact that volatility has on the performance of your portfolio as you will be averaging the cost price over a duration of time instead of trapping yourself with a single price on a single date.

5.3 Manage your risk properly

While market timing is a fool's errand, that doesn’t mean you should just buy and forget or set the DCA and forget.

To properly manage and deal with volatility, you will need to manage your investment portfolio risks and take the necessary action to increase or reduce the risk that you are exposed to depending on your analysis.

Long story short, if based on your analysis, you realize that the market is currently overvalued and risky, you might want to sell off some of your investments to reduce the risks exposed and be more defensive.

That way, in an event where the market corrects itself to normal levels, your overall portfolio will not be that impacted by the downside volatility.

Likewise, if based on your analysis, you realize that the market is currently undervalued and presents an opportunity, you might want to invest more and take on more risk to be more aggressive.

That way, in an event where the market goes back to its normal levels, you will be able to benefit from the upside volatility.

6. Summary

Long story short, volatility, if not managed properly is bad for investors regardless of whether or not you are investing for the short or long run.

Volatility results in an irrational emotional decision that may sabotage your performances and mathematically, volatility drag poses a real threat to your long-term wealth if you do not manage the downside volatility carefully.

The way to work around, manage and mitigate your volatility is to plan and position yourself financially, rely on dollar-cost averaging and manage your investment portfolio accordingly to ensure that you are not taking on too much unnecessary risk at any given point in time.

Daniel is a Licensed Independent Financial Consultant with MAS and a certified Associate Wealth Planner that provides: