Volatility is often a misunderstood concept for investors. It is important to recognize the distinction between volatility and market risk.
Volatility represents the price movement of a security, and it is usually calculated through metrics like standard deviation and variance. On the other hand, market risk is the possibility of losing money in the financial markets even if your portfolio is diversified[1]. While market risk can result in permanent financial loss, short-term volatility does not necessarily equate to a loss of money.
Historically, financial markets have experienced numerous periods of heightened volatility, often triggered by economic recessions, geopolitical events, or unexpected global crises like the COVID-19 pandemic. Understanding that these periods are cyclical and not permanent can help investors remain focused on their long-term goals.
Behavioral finance research suggests that investors often make emotional decisions during volatile markets, such as selling off assets during a downturn[2]. These decisions are typically driven by fear of loss which can be difficult to overcome in the moment. Recognizing this tendency can help investors avoid common pitfalls and make more informed choices.
Staying Calm Amid Volatility
Let’s explore how staying calm and diversification can help investors manage volatility. The chart below illustrates the yearly returns of the S&P/TSX Composite Index, alongside the lowest intra-year return (indicated by the dots) for each year (between 2001 and 2003). The grey line represents the average annual return for the period.
Source: DFA Returns Web
As demonstrated, the worst intra-year returns can be alarming for investors, but the overall annual returns are often more reassuring. For instance, in 2020, the lowest monthly return for the S&P/TSX Composite Index was -17%, yet the calendar year ended with a positive return of 5.60%. This pattern suggests that despite negative intra-year returns, annual returns can still be positive.
2008 was a special case with the Financial Crisis and the market crash. Despite a lower single intra-year decline, multiple declines throughout the year resulted in a compounding effect of lower annual return. Nonetheless, it also shows the importance of staying calm. Let’s assume that the S&P/TSX Composite Index is directly investable and consider two hypothetical investors: Investor A and Investor B. They each invested $1,000,000 in the index at the start of 2001. Investor A panicked during the 2008 downturn and liquidated his portfolio on December 31, 2008, when it was worth $1,189,075.
When the index bounced back in 2009 with a substantial annual return of 35%, Investor A reinvested all his money, which had remained uninvested throughout 2009, at the start of 2010. On the other hand, Investor B remained calm all the way and stayed invested throughout the period. At the end of 2010, the portfolio value of Investor A was $ 1,398,421 and Investor B’s portfolio value was $1,888,637.
Please note that indices are not directly investable, and performance does not account for the expenses associated with an actual portfolio.
The Power of Diversification
If volatility still seems concerning, we next show how diversification might provide some relief in the chart below.
Source: DFA Returns Web
The chart above shows the same data for a 60/40 index portfolio comprising Canadian Equity, US Equity, International Equity, Canadian Fixed Income and Global fixed Income, along with the previous chart. Compared to the S&P TSX Composite Index, it is less volatile and has more positive calendar year returns during this period. For example, the lowest intrayear returns were -8.38% and -16.67% for the 60/40 portfolio and the S&P/TSX Composite Index respectively between 2001 and 2023.
Conclusion
Volatility is an inherent part of investing, but with a long-term perspective and a disciplined approach, investors can navigate its challenges. By staying invested, avoiding emotional reactions, and diversifying their portfolios, investors can ride out market fluctuations and stay on course to achieve their financial goals. The key is to remain focused on the bigger picture, understanding that short-term volatility does not equate to long-term loss.
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson Wealth or its affiliates. Assumptions, opinions and estimates constitute the author's judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. The comments contained herein are general in nature and are not intended to be, nor should be construed to be, legal or tax advice to any particular individual. Accordingly, individuals should consult their own legal or tax advisors for advice with respect to the tax consequences to them, having regard to their own particular circumstances. Richardson Wealth is a member of Canadian Investor Protection Fund. Richardson Wealth is a trademark by its respective owners used under license by Richardson Wealth.
1 https://www.chase.com/personal/investments/learning-and-insights/article/market-risk-vs-volatility-three-key-differences#:~:text=Market%20risk%20is%20the%20possibility,easily%20(and%20often)%20measured
2 Shefrin, H. (2000). Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Harvard Business School Press.