What Is Market Volatility?
Understanding volatility is crucial for investors as it allows them to assess the level of risk they are willing to take. During periods of high market volatility, you might need to re-evaluate your risk tolerance. This means being honest about what you can handle without feeling panicked or making impulsive investment decisions.
In the context of investing, volatility refers to the statistical measure of the dispersion of returns. Volatility is typically calculated using the standard deviation, which measures how much the returns of an investment vary from its average price or value. This statistical measure helps investors understand the potential range of price fluctuations and risks associated with a particular investment.
Two Do’s and One Don’t When Markets Are Volatile
Investing should be boring. Dull financial markets are calm, individual investors stay invested, and there are few reasons to panic. When market conditions start getting volatile, investors might feel they need to do “something.” When volatile market moves feel like a gut punch, re-evaluate your risk tolerance. It might be time to rebalance if you haven’t reviewed your portfolio in the last six to twelve months. Above all else, don’t panic.
Do Re-evaluate Risk Tolerance
Periodic risk tolerance evaluation is necessary to verify that you have been honest with yourself. Most of the time, your overall tolerance will not change dramatically. But how you feel about specific questions might change. After a 5-year bull market, when almost any equity doubled in value, you might think you can handle a 20% loss. But when you suddenly realize a 5% loss in three short weeks, that previous “I can take anything…” could quickly change to “I feel breakfast coming up…”
Take the time to reassess your risk tolerance. This involves evaluating your financial goals, time horizon, and emotional ability to handle fluctuations honestly. Ask yourself if you can endure potential losses without panicking or making impulsive investment decisions. If your risk tolerance has changed, adjust your investment strategy accordingly.
Please note that “adjust” is not an all-or-nothing endeavor. It’s a minor allocation change, maybe moving from 75% high-risk/25% low-risk investments to 70%/30%.
Do Rebalance If Needed
Rebalancing your investment portfolio is an essential strategy to manage risk and maintain proper asset allocation, especially during periods of market volatility. Rebalance frequency refers to how often you review and adjust your portfolio’s holdings to align with your desired risk tolerance.
The importance of rebalancing lies in its ability to keep your portfolio on track and within your desired risk parameters. Market volatility can cause certain investments to outperform or underperform, leading to a drift in asset allocation. Regularly rebalancing ensures that your portfolio remains diversified and aligned with your risk tolerance.
During periods of high market volatility, investors must resist the urge to panic. The stock market is known for its ups and downs, and panicking can lead to poor investment decisions that may result in significant losses.
Panic selling, in particular, can be detrimental to long-term investment returns. Selling stocks during a market downturn locks in losses and prevents investors from benefiting from potential recoveries. Market volatility is often temporary, and history has shown that equities tend to increase over time. By panicking and selling in a downturn, investors may miss out on the opportunity to recoup their losses and potentially even earn gains.
Focusing on long-term goals to manage emotions during volatile times is essential. Market fluctuations in the short term should not overshadow the overall objective of growing wealth over an extended period. Maintaining a diversified portfolio is also crucial. A well-diversified portfolio spreads risk across different asset classes and sectors, helping mitigate market volatility’s negative impact on individual stocks or sectors.
Seek professional guidance if needed. If you find evaluating your risk tolerance or developing a well-diversified portfolio challenging, consult a financial advisor who can provide expert advice tailored to your circumstances.