They have names like the Intimidator, Tower of Terror, and that classic: the Cyclone. But I think the most unnerving monster of a roller coaster goes by the name Market Volatility.
Amusement park thrill rides can be fun, but roller coaster-type returns in your portfolio – the sharp swings in value up and down over relatively short periods of time – aren’t very amusing, and could be detrimental to your investment goals.
It wasn’t so long ago that investors had become incredibly complacent about market risk and volatility. The greatest danger in low-volatility environments is that, because nothing bad has happened for a while, investors tend to become increasingly aggressive, which can lead to bubbles in the marketplace.
Market volatility has increased dramatically over the last few years, and appears to be more the rule than the exception. We’ve had event-driven swings such as the bursting of the tech bubble in March of 2000, 9/11, and the 2008-2009 Financial Crisis. Legislative uncertainties, fiscal and monetary stimuli, European sovereign risk, U.S. debt, and economic globalization and the growth of emerging markets have all impacted market volatility. Furthermore, the speed at which information is communicated via 24/7 financial news networks and the Internet and the growth of high speed/frequency trading have contributed to unsettled markets – trends that look to continue for the foreseeable future.
Naturally, investors are concerned about the effect volatility is having on their portfolios and are looking for ways to help mitigate or smooth out the impact. Why is it so important to lessen volatility? For the simple reason that compounding (the return that’s calculated not only from the initial investment amount, but also on any accumulated return of prior periods) results in greater investment outcomes when there’s less volatility in the portfolio return, as the following hypothetical example shows:
Both Fund A and Fund B had the same average return of 10% over the 5-year period. However, Fund A’s performance was much more consistent (less volatile) and, therefore, lead to a higher amount after year 5. Despite having the same average rate of return, Fund A was worth over 4% more than Fund B.
In a follow-up post I’ll share ideas to help moderate the problematic effects of market volatility.
A mutual fund’s share price and investment return will vary with market conditions, and the principal value of an investment when you sell your shares may be more or less than the original cost.
Past performance is no guarantee of future results.
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