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Understanding Market Volatility & Why It Isn’t Always Bad

Understanding Market Volatility & Why It Isn’t Always Bad

Since the beginning of the pandemic, the stock market sure has given investors some reasons to feel concerned. It’s been a rollercoaster of ups and downs from the crash in March 2020 to the huge bounce back that more than doubled in value, and then another dive and the rise of inflation.

For many, it sure has been tempting to just get off the ride. But volatility isn’t always a bad thing. No, really. Understanding what it really means, and how it can help you in the long run, may help to clear the bad rap it gets in the media.

Market Volatility Does Not Equal Risk

Let’s get this out of the way up front. Market volatility does not presuppose more risk.

Market volatility is simply a measure of how great of a degree stock prices are fluctuating in value at any given time. It actually has nothing to do with increased risk, which is a common misconception.

Yes, when the market is more volatile, stock prices can take big, and often unpredictable, swings up or down (or both up and down—sometimes in the same day). But, believe it or not, swings in either direction present their own potential money-making opportunities. There is upside potential in any market.

Of course, risk isn’t completely divorced from volatility. Some stocks are considered riskier investments because they are more vulnerable to swift changes in price over time. That is, they don’t have a strong history of consistent returns. But this also doesn’t make these more volatile stocks bad for your portfolio. It just means you don’t want them overconcentrated in your mix of investments.

What About Extreme Volatility?

Lots of different things can cause extreme market volatility to occur, especially when one or more factors combine. The most influential factors tend to be:

  • Changes to government policy
  • Upcoming elections
  • Banking crisis (such as the 2008 Great Recession)
  • New or changing tax laws
  • Rising inflation
  • Investor behavior and attitudes

Any of these on their own can lead to overvalued or undervalued stocks, but it is often a mix of a few that cause extreme selloffs.

You see, what’s interesting is that these factors on their own don’t cause the price of stocks to change. It is mass investor behavior in response to these factors that does it. When investors sense enough uncertainty, they panic and sell securities in droves (with the express intent of staving off potential loss that could occur from what they perceive could be a downturn). This creates a perfect storm that can send prices down exponentially faster.

How Volatility Can Be Good

But don’t panic. Volatility is normal and can mean opportunity. The past two years have definitely caused us some trauma, and rightly so. However, if you look longer term, volatility seems a lot tamer.

In reality, bear markets have only happened 30% of the time (or every fifth year) since World World II, and the stock market has grown by 3,000 times since then (specifically since 1950). This means that bouts of volatility, even extreme volatility, that have caused the market to decline have merely been blips on a long-term climb up. Volatility can actually spur the markets to climb higher.

Make Volatility Your Friend

That old cliché of it being a marathon and not a sprint rings true when it comes to market volatility. Don’t get yourself all worked up by looking at returns every day, week, month, or even a year.

There can be the temptation to time the market by getting in and out when volatility starts going wild. But that usually ends in selling low, re-buying at higher prices, and ending up with an overall loss.

Instead, stay the course and focus on these three time-tested principles:

  • Diversify your portfolio: Going all-in on one kind of investment is risky behavior. Instead, choose a mix of investments that have a low correlation to each other, meaning they won’t all do the same thing when the market declines. The better optimized your portfolio, the better it will withstand volatility.
  • Keep your eye on the prize: You’ve established long-term goals for retirement, house buying, college funding, etc. Stay focused, and don’t let everyone else’s panic affect you. Remember the long-term climb of the stock market and that the volatility will be short-lived.
  • Stay disciplined: Again, the stock market has always rewarded those who have been patient and disciplined. Make “I will not sell low and buy high. I will not sell low and buy high.” your mantra and turn off the talking heads on TV.

And if you don’t have one already, find a financial advisor who can help you establish goals, create a diversified portfolio, and help talk you out of behavioral temptations while investing.

More About the Author: Sheena Hanson

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