When market volatility occurs, it is common for investors to deviate from their strategy and act with emotion which causes them to sell down investments to cash to avoid seeing a drop in their holdings. However, understanding market volatility is critical for investors who wish to ensure they continue to boost their investment returns and overall performance, irrespective of short-term noise. To find out the best ways to reduce the impact of volatility on your portfolio, continue reading below.
What is volatility?
Market volatility refers to the statistical measure of the tendency of a market or security to rise or fall sharply within a short period of time. The main thing to understand about volatility is that it is inevitable and therefore it is in the very nature of the stock market to see rises and falls in the value of particular investments. The riskier an investment, the more likely it is to be volatile, whereas more defensive investments are likely to remain relatively stable overtime, but the returns generated are often lower than growth assets.
What causes market volatility?
Volatility is often caused by changes in economic or market conditions. This can include particular announcements or economic releases from Central Banks as well as individual companies. Volatility can also be caused by political events which impact global economies as well as macro-economic events such as rising inflation and interest rates. Volatility also occurs as a result of the behaviour of investors which is caused by a psychological responses to market uncertainty and fear, and thus the combined effect of individuals selling their holdings results in further market drops.
How can I reduce the impact of volatility on my portfolio?
Long-term investment strategy
One of the ways investors can reduce the effects of volatility is through adopting a long-term investment strategy. This is an approach that encompasses holding certain investments for an extended period of time with minimal changes during both market downturn and market growth.
Following this strategy means that instead of reacting to short-term noise which includes sharp rises and falls in the market, individuals continue to retain their investments throughout this time. So, instead of selling your investments in times of market downturn, investors are encouraged to hold and wait for market conditions to recover, which will mean that you are investing over a longer period of time and therefore are able to enjoy greater returns as a result. For example, the S&P500 over the last 25 years has produced an annual return of 11.4%. If investors sold out every time market volatility occurred such as during the 2007 GFC and COVID-19 pandemic, their returns would likely have been significantly lower.
The advantages of this approach also include that it is less time consuming as it does not require you to spend time monitoring day-to-day market fluctuations. It is also likely to reduce the associated costs of investing as constantly buying and selling comes with higher brokerage, buy-sell costs, and implementation fees. It should also be noted that investors who choose to hold an investment for more than 12 months may mean that they may be able to claim a tax concession on any capital gains. To read more about this, click here.
Dollar cost averaging
Another way to reduce the degree to which market volatility impacts your portfolio is through dollar-cost averaging. This refers to the process of investing in smaller, fixed amounts regularly over a longer period of time. The benefit of this strategy is that during times of market downturn particular investments are trading at lower costs which in effect means that investors can purchase them at a discount and when combined with other purchase prices, overtime averages out. This also has the potential to maximise your returns, as once the price of particular investments recover you will be able to enjoy greater returns as your bought in at a lower price. This is also suitable for investors who may not have access to large sums of money and therefore this strategy allows you to purchase units at a lower price whilst also being exposed to the market.
Only invest money you won’t need
A significant downfall for some investors is that volatility and market downturn means they are forced to sell down their investments and withdraw the cash to cover their cost of living. Individuals who do not have access to sufficient funds and have to withdraw from the market as a result are disadvantaged as they are not invested and thus will not benefit from the returns generated once the market has recovered.
Therefore, a major consideration should be for investors to ensure they have adequate cash outside of their portfolio to cover both their living expenses as well as any other ad-hoc or emergency expenses that may arise. Having an emergency fund could be one of the best financial decisions you make as it will help to ensure that you have enough cash to cover life’s unexpected events such as medical emergencies or sudden job loss and can reduce the chances of going into debt. To read more about establishing a cash reserve, please click here
This will help to prepare investors and ensure they remain financially stable and have liquid cash during times of uncertainty such as rising inflation and market volatility. To read more about the importance of retaining a cash reserve click here, or to determine whether you should pay off your debt or invest, please click here.
If you would like to arm yourself with tailored and specific financial advice that is relevant to your personal circumstances and provide you with peace of mind during the uncertainty that is yet to come, please click here to book in a complimentary 20-minute phone call with an EPG Wealth adviser.