Stock markets are an incredible tool for wealth building. However, they also have a slightly uncomfortable characteristic, which is unfortunately inherent – volatility.
Market volatility simply refers to the unpredictable short-term fluctuations of assets prices – or company stocks – that make up the overall market.
Volatility is often described as the “price of admission” – to access stock markets and the superior long term returns they provide, the price you must pay is short-term market volatility.
Today, we’ll explore the concept of market volatility, how it is caused, and how it impacts both investor confidence and behaviour.
Is Market Volatility Normal?
Yes, and this is an idea that you should become comfortable with before you start investing.
Market volatility is a feature, not a drawback. A constant state, not a chance occurrence.
It’s important to understand that there will always be a certain level of market volatility due to the stock market’s high level of liquidity.
Liquidity is a good thing, because it means that you can access your money and convert assets into cash very quickly should you need it. However, to do that, the assets must be priced every single day (so inevitably these prices change daily).
Compare this to a less liquid asset, like your house or your car – it’s only priced when you decide to sell it. Therefore, you are more numb to the day to day situation – you can’t easily convert it into cash, and you don’t see the daily price somebody else is willing to pay for it.
However, from time to time, investors will also face periods of more extreme market volatility. This is also normal, though considerably more difficult to live through for investors. We’ll explore this more below.
What Causes More Extreme Market Volatility?
The Economic Cycle – Economies tend to run in cycles, expanding and contracting over time. To give you an example of this, the latest statistics from the National Bureau of Economic Research show that the average economic cycle in the US between 1945 – 2020 lasted 6.2 years.
More extreme market volatility is common during the “bad times” of the economic cycle, as the economy contracts and approaches the bottom (or the “trough”).
Economic Indicators – Short term market prices can be sensitive to economic indicators such as GDP reports, employment figures, inflation, or releases of economic data (especially during the “bad times” within the economic cycle).
Geopolitics – Geopolitical events or tensions can lead to market fluctuations. For example, tensions between countries, trade disputes, wars, or other international conflicts.
Investor Sentiment – Market sentiment can shift rapidly due to factors like social media trends or news reports, leading to poor investor behaviour.
Retail investors are particularly susceptible to knee jerk reactions and emotional decision-making during periods of market volatility, which can cause further volatility or sudden changes in short term asset prices.
External Shocks – these are unexpected events that shock the system, disrupt markets, and increase volatility. Examples would include disease outbreaks (e.g. COVID-19), terrorist attacks (e.g. 9/11), or natural disasters (e.g. 2004 Indonesian Tsunami).
How Does This Impact Investor Confidence and How People Behave?
Fear and Uncertainty – Just like the most extreme loops on a rollercoaster, increased market volatility can be fear inducing for investors.
When prices swing wilder and faster than investors are used to, it can cause uncertainty and panic, leaving investors more likely to sell their assets due to fear of further losses.
Loss of Focus/Disproportionate Focus on the Short Term – High levels of market volatility result in a higher stress environment, which can cause investors to “stray from the path”, drifting away from their plans and losing focus of their long-term goals.
This focus on the short term makes investors more likely to react impulsively or make emotional decisions based on daily price movements, decisions which are not aligned with their long-term goals and will damage their chances of achieving them.
Punishing Poor Planners – Market volatility can have a significant impact on investment accounts, like retirement pots. For people who have not planned properly, sustained periods of market turbulence can remove choice and force suboptimal actions (or in some cases, actively damaging actions).
For example, picture John, who retired in 2022 during a period of market turbulence.
John had not engaged in any retirement planning previously and had not prepared for it at all.
With his salary now dropping away, John had to fund his retirement spending by withdrawing from his retirement pots, which are all invested. Unfortunately for John, asset values were down.
So, John had no choice but to sell assets when prices are low, realise losses, and take years off the sustainability of his retirement nest egg, just to fund his retirement spending today.
Another such example is someone who loses their job but has no emergency fund in place – again, they are forced to sell from investment pots to keep the lights on, realising losses that will compound long into the future.
So How Can You Navigate Periods of Extreme Market Volatility?
Have a Financial Plan and Clear Goals – Whether it’s saving for retirement, buying a home, or funding your children’s education, it’s important to have clear long-term goals and a plan for how you are going to achieve them.
This will give your goals an emotional attachment and provide you with the right motivation to achieve them.
Having clear long-term goals gives money purpose, helps you to remain focused on the right things, and provides an anchor during periods of market turbulence.
Long Term Focus – Keep your long-term goals in mind and resist the temptation to make impulsive decisions based on short-term market fluctuations. These periods are temporary, and staying focused on your long-term vision is crucial for success.
When Thinking Short Term, Stay Goals Focused – when you do think about short term factors, it’s important to remain rational and keep your thinking goals-focused, not hysteria driven.
It’s important to tune out the noise and avoid emotional decisions or knee-jerk reactions.
However, you may genuinely have short term goals and periods of volatility can often be a trigger for reviewing your Financial Plan and how you are progressing towards your goals.
For example, picture David & Jane – they are planning to purchase a house in 12 months’ time. David & Jane have been saving into a short-term vehicle for this (a standard savings account with their local bank).
However, after reviewing their situation, the changes in the economic landscape during 2022, and where they are against their goals, David & Jane have realised that their long-term goals are unaffected but rising interest rates have presented an opportunity for their short-term planning.
Therefore, they have now decided to change the short-term vehicle they are using to house this money, taking it out of the savings account paying 0% interest and reallocating the money to a 12-month fixed term deposit paying 4% interest.
David & Jane’s goals have not changed, their timelines have not changed – but through clear thinking and goals-based planning, they were able to identify a more optimal route to achieving it.
When you act during turbulent times, make sure you are planning for your goals, not reacting to noise.
Have a Clear Investment Philosophy – this will give you belief and conviction in the way that your money is invested. A clear investment strategy will be set up specifically to withstand periods of volatility, which will make living through such periods much easier to absorb.
Without a clear investment philosophy, investors have low levels of confidence in how their money is invested. When periods of volatility come along, it can then become very easy – and potentially justified – to second guess why the money was invested in that way to begin with.
With no confidence in how your money is invested, and no clear plan on how it should be invested, emotional reactions and poor investment decisions are usually made.
If you find this point relatable, read our investment philosophy here.
Diversification – Although this falls under having a clear investment philosophy, it is an important enough factor to warrant its own point.
A well-diversified portfolio is vital to navigating periods of market volatility, as this will spread risk and soften the impact of sudden market swings.
Reassessing Your Relationship with Risk – Our investment portfolios are constructed in line with our Capacity for Risk and our Risk Tolerance (read more on the difference in our article here).
Whilst your Capacity for Risk is based on cold hard numbers and will likely remain unchanged, periods of volatility will test your Risk Tolerance, which is more subjective and psychological.
If you find that you are having sleepless nights, then it might be time to reassess your Risk Tolerance and adjust your portfolio accordingly.
It’s usually better to ride out the current short-term volatility and action this once the portfolio recovers, but this will make sure that you are better prepared for the next period of heightened volatility (which based on the statistics mentioned earlier, you should expect to happen every 6.2 years on average).
This will reduce your returns in the long run but ensure a more comfortable investor experience over the short term – this is very personal and it’s important to get this balance right for you.
Continue to Save Regularly – for most people, they are paid monthly, and this means allocating a set amount of savings to your investment accounts each month.
If your goals remain unchanged, then it’s important to keep this up and continue to save and invest regularly throughout tougher periods in markets.
By doing so, you are buying more shares when prices are lower, smoothing out the impact of market volatility over time and accelerating yourself along your path towards achieving your goals.
Review Your Emergency Fund – Having an emergency fund is a fundamental part of any Financial Plan.
This provides a safety net for unexpected expenses and can prevent you from having to dip into your investments during periods of volatility or poor market performance.
Such periods in markets bring your emergency fund into sharp focus – if you don’t have one, it’s a good time to establish one. If you have one, it’s worth running the numbers again and just making sure it’s enough.
If there is any shortfall here, an easy way to address this is to redirect your regular monthly savings towards topping up your emergency fund. Once you have established a sufficient emergency fund, you can then resume your usual monthly investing.
Professional Advice – If you are nervous or unsure of anything, seek professional guidance from a Financial Planner. They can help you to define your goals, formulate a comprehensive Financial Plan, provide valuable perspective and insights, and help you to make informed decisions for yourself.
This can be particularly helpful during periods of market volatility.
If this is an avenue you would like to explore, please do get in touch. Alternatively, you may also be interested in this article which will help you to choose the right Financial Planner.
Conclusion:
Market volatility is a reality that investors must navigate.
Although standard levels of volatility should be expected day to day and month to month, it can be significantly more testing when periods of more extreme volatility come along every few years.
This can have a profound impact on investor confidence.
To weather the storm of market volatility and maintain confidence in their investments, individuals should ensure they have a clear Financial Plan and a clear investment philosophy underpinning it.
They should remember to stay focussed on long-term goals, diversify their portfolios, review their circumstances regularly, and remain disciplined in their approach.
Although they can be uncomfortable, periods of turbulence are very normal. By understanding the causes of market volatility and zooming out to put things in context, investors can better manage their expectations, make informed decisions during turbulent times, and stay on track to achieve their goals.
If you have any questions about anything in this article, or if you would like to discuss your own personal circumstances, please get in touch.
By Technical Team @ Abacus
Please keep in mind that, whilst we aim to update these articles periodically, the content could be subject to future rule changes. Always make sure to speak to a qualified professional to ensure you have the most up to date information and are taking regulated advice around your specific circumstances.