This is the first in a series of blogs which set out to explain what volatility is, how it can affect your investments and what might be the best way to respond to it. Here, we look at why the best view on short-term volatility might be to simply look through it and remember your long-term goals.
What exactly is volatility?
Volatility is the movement of prices in a market. When markets move, especially if they move downwards in a short space of time, it can be a real cause for concern for investors. Without wider perspective, such movements – which might be interpreted as a price correction, a sudden drop in confidence, a reaction to major event, or more likely a combination of all of these – can look like a good time to take your investments out of the market. However, as we’ve seen over the period of the Covid pandemic a better course of action might be to leave your investments in the market and see through the volatility. This is because volatility should be seen in the context of investing for the long-term.
Why a long-term view is important when it comes to volatility
By its very nature, market volatility is a short-term phenomenon. When prices of a certain stock or within a sector or index start to move downward rapidly, money might flow out of that position as investors try to leave before they lose more value – this can then cause the asset price to fall further. Conversely, this can then lead to some investors buying back into the market because they now see it as undervalued, and this buying can cause prices to rise again.
This is an important point: volatility refers to market movements – both up and down – in a short space of time. When we see it happen over the long-term, we understand it as the natural movements of the market. Historical data suggests that typically the VIX (a real-time market index representing the market’s expectations for volatility over the coming 30 days) can go up very quickly but tends to reverse toward long term mean afterward.
Source: Macrobond, Bloomberg Jan 1990 – April 2021
How do we measure volatility and why is the long-term context important?
The volatility ratio used by investors creates an expected range of price change for a set future time period. This can be a day, a month, a year or longer. If prices are making large, rapid moves then the implied volatility is high; if they are more stable, then the implied volatility is low. When the Covid pandemic became global in March 2020, equity market volatility for the MSCI global equities index was very high. The daily average for that month was 77.76% as a percentage of how much prices might be expected to move. However, a year later the daily volatility average for the MSCI global equities index from March 2020 to March 2021 was much lower: 17.92%. If we take a ten-year historical daily average, we can see that between 2011 and 2021, volatility for the MSCI global equities index was 14.93%. By staying invested for the long-term we can see that historic data suggests the effects of volatility can be lessened, especially when contrasted to a very short-term window of high volatility.
Why volatility can mean profit
Volatility isn’t inherently bad. If there was no volatility (price movement) there would be no market; so, a certain level of volatility is necessary to allow markets to give returns. Finally, it’s worth looking at the overall market performance to see how volatility tends to settle down in the long-term, while total returns can rise – rewarding the long-term investor who has seen through the volatility and stayed in the market. If you’d stayed in the market following the volatility which hit at the beginning of the pandemic, then you could have benefitted from MCSI global equity index total returns of 54.62% between March 2020 and March 2021. Thinking more long-term, if you’d stayed invested over the last ten years, through all the pockets of volatility that arose you could still have benefitted from global equity index total returns of 171.06% between March 2011 and March 2021.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.