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The role of volatility

Volatility levels can sometimes make investing feel like a rollercoaster but volatility, or risk, in other words, is what allows investors to make returns. Risk and return are closely linked. 

Standard deviation measures the risk of an investment portfolio. It tells you how close or far from the average your returns might be in any given period, i.e. a low standard deviation means returns can be expected not to vary much from the average and the reverse is true for a portfolio with a high standard deviation. 

A popular measure of volatility used amongst investors is the VIX Index (often called the ‘fear index’). During the Global Financial Crisis, the VIX spiked into the 80s, whereas it more usually sits between 10 and 30, perhaps moving into the 40s in more volatile periods, such as during the tech crisis in the early 200s and the Asian debt crisis in the late 1990s. In March 2020, at the outset of the Covid crisis, the VIX hit 76. When volatility goes up so sharply, history shows us it tends to take some time to come back down again. The Ukraine crisis has seen volatility levels spike once again, but not to the same extent. 

The heightened volatility is a sign that the markets continue to function as they should. The news cycle is accelerated at times like these and prices seesaw as the new information is priced in. The effect of the event on the real economy and cash flows, and the risks associated with them need to be assessed and incorporated into prices. 

There are some technical trading considerations which affect volatility. The cost of trading is higher in volatile markets as the spread between buy and sell prices widen out. For the S&P500, the difference between bid and offer prices is usually less than 1 basis point. This moved to 5 basis points in recent weeks. The effect is even more marked in small cap stocks. Prices also tend to move further with each trade as liquidity is lower and there are fewer stocks traded at any given price. 

Without volatility, however, there would essentially be very little risk in the market. Risk and return are related so to access the higher returns that equities generate over time, relative to less risky investments such as bonds and cash, risk is an essential part of the investment process. Whilst sharp spikes in volatility are uncomfortable on an emotional level and there is always a part of our minds that poses the question, “Is there something different this time?”, rational thinking is imperative. 

Discipline is crucial at times of high volatility. Whilst it may be uncomfortable, staying in your seat is important – you don’t get out of the rollercoaster until it stops. Then, if you decide the peaks and troughs of the big rollercoaster are not for you, you can assess whether you need to lower your risk profile and make changes to your asset allocation, if that works for your financial goals. The critical thing to remember is to make decisions without emotion. 

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