Webster’s dictionary defines the word volatility as “characterized by or subject to rapid or unexpected change.” Interestingly, Webster cites the stock market as one example of this definition.
Which brings me to the point of this month’s commentary: market volatility.
Volatility is an inherent element of the financial markets. It is studied and measured by investors and traders to glean insights into market trends or to make forecasts. A study by Crestmont Research shows that periods of higher market volatility tend to be more highly associated with periods of declining markets, and vice versa.
The stock market has continually gone through periods of high and low volatility. This year, stock market volatility has been elevated considerably as a result of the confluence of a number of factors that have interjected increased 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 investors’ outlooks and expectations and, ultimately, stock and bond prices.
Interest rates also affect valuations (what investors will pay for a stock or bond), which are key component to securities prices. The higher interest rates experienced this year have resulted in downward pressure on valuations for stocks and bonds.
Newsflow has a significant impact on daily volatility. Lately the news has been feeling a little like a pinball machine: minute-to-minute feeds of bouncing between good news and bad news. This “back and forth” swing in the news contributes to increased daily volatility and is further exacerbated by algorithmic (computer-driven) trading. Uncertainty about a limited number of issues can markedly increase investor concern (and market volatility) but when three or four major issues are of high concern, like we have currently, it can significantly increase market volatility which we have seen so far this year.
Ironically, volatility is an essential component to higher investment returns. This is 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 likelihood of that is low. It is also important to remember that investment volatility can be managed to some degree through portfolio diversification.
As financial planners, we embrace diversification through recommending investing in multiple asset classes such as stocks, bonds, commodities and real estate within one portfolio. This strategy has proven over long periods to deliver good returns with lower overall risk, thereby providing higher risk-adjusted returns which I believe is the most important measure of performance in managing client assets.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.