Webster’s dictionary defines the word volatility as “characterized by or subject to rapid or unexpected change.” Interestingly, Webster cites the stock market as an example of this definition.
Which brings me to the point of this month’s commentary: market volatility.
Volatility is an inherent element of financial markets. Investors and traders study and measure it to gain insight into market trends or to make forecasts. A study by Crestmont Research shows that periods of higher market volatility tend to be more closely associated with periods of declining markets, and vice versa.
The stock market has continuously gone through periods of high and low volatility. Stock market volatility has increased considerably this year as a result of a confluence of factors that have introduced greater uncertainty about things that are important to investors. These factors, to name a few, include the outlook for inflation, geopolitical instability, corporate earnings and the impact of Federal Reserve policies. All of these issues factor into the outlook and expectations of investors and ultimately the prices of stocks and bonds.
Interest rates also affect valuations (what investors will pay for a stock or bond), which are a key component of stock prices. The higher interest rates experienced this year have put downward pressure on stock and bond valuations.
News flow has a significant impact on daily volatility. Lately, the news has felt a bit like a pinball machine: bouncing between good news and bad news minute by minute. This “back-and-forth” switching of the news contributes to daily volatility and is further exacerbated by algorithmic (computer-driven) trading. Uncertainty about a limited number of issues can significantly increase investor concern (and market volatility), but when three or four major issues are of major concern, as we currently are, it can significantly increase the market volatility we’ve seen so far this year.
Ironically, volatility is an essential component of higher investment returns. Here’s what 200 years of history has shown us: Investors should expect, and have historically received, a higher return for taking on the higher risk of owning stocks. This axiom could change tomorrow for some unknown reason, but we think the probability is low. It is also important to remember that investment volatility can be managed to some extent through portfolio diversification.
As financial planners, we embrace diversification by recommending investing in multiple asset classes such as stocks, bonds, commodities and real estate within a portfolio. This strategy has proven over long periods to deliver good returns with lower overall risk, thus providing higher risk-adjusted returns, which I believe is the most important performance measure in client asset management.
Robert Toomey, CFA/CFP, is vice president of research at SR Schill & Associates in Mercer Island.