Market volatility and financial risk are inevitable, especially with the stock market’s wild swings that can make even seasoned investors feel like they’re on a roller coaster ride. But volatility is nothing new and is an unavoidable aspect of investing. In fact, volatility is what creates opportunities for wise selling and buying in the markets, Recent reports summed up the current state of the market by saying, “U.S. stocks are rallying in near unison on Friday as they close out a bumpy week that had been dominated by sharp, market-cleaving swings.” From the dizzying highs to the stomach-churning lows, market volatility can test the resolve of anyone with financial goals.
However, market volatility isn’t always the villain it’s made out to be. In fact, volatility creates opportunities for wise selling and buying in the markets. Unfortunately, volatility is often mistakenly equated with risk, especially in the financial media and, more importantly, in the minds of investors.
While a link will always exist between the two, market volatility and financial risk attempt to gauge two very different things. Understanding the difference can play a vital role in building a smart investment strategy.
Market Volatility & Its Relationship with Financial Risk
Volatility and risk in the stock market are distinct but related concepts that play crucial roles in any financial planning and investment strategy. While both can change across a specific time period, volatility is the more visible market variable, whereas risk often remains abstract and elusive. Understanding these elements is essential for working toward your financial goals in a dynamic market environment.
Volatility is a measurable market characteristic, observable through daily price movements of indices like the S&P 500. The S&P 500 is an index that includes 500 of the largest U.S. companies, providing a broader view of the market compared to indices with fewer components. While individual stocks fluctuate based on company-specific factors, the S&P 500 captures the overall market trend. Market volatility becomes particularly pronounced when these 500 stocks move in unison, potentially leading to significant point gains or losses in the index. For example, on March 16, 2020, the S&P 500 plummeted 12%, its worst day since 1987. Such dramatic swings exemplify high volatility and can significantly impact your investment strategy.
Market volatility can amplify financial risk by expanding the range of potential investment outcomes. Still, it’s important to note that higher volatility doesn’t always equate to increased risk in your investment strategy. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. However, a properly diversified portfolio should include components that do not move in the same direction, as low correlation between assets can help reduce risk.
Market volatility feels most real in a pattern where stock prices tend to rise gradually but fall rapidly, leading many investors to experience losses during periods of extreme fluctuations. This phenomenon underscores the importance of having a well-thought-out financial plan that accounts for such market behavior and your ability to stomach the ups and downs. While short-term market volatility can be unsettling, a seasoned financial advisor would likely emphasize that these fluctuations often become less significant the longer it is before you need the money. In other words, volatility doesn’t matter much if you have a long-term investment horizon.
Measuring Market Volatility: Standard Deviation vs. Beta
When developing a financial plan and investment strategy, two key metrics are often used to measure volatility: standard deviation and beta. Each offers unique insights for investors and financial advisors when crafting investment strategies aligned with specific financial goals.
Standard deviation is a statistical tool widely used in finance to quantify volatility relative to a stock’s average price movement. A higher standard deviation indicates that a stock is prone to price swings. Essentially, it measures the predictability of a stock’s returns compared to its own average, making it a valuable metric for assessing individual security volatility in isolation.
Beta serves as a comparative measure of volatility. It compares a stock’s volatility to that of the overall market, often using the S&P 500 as a benchmark, which has a beta of 1.0. A beta above 1.0 indicates that a stock is more volatile than the market, while a beta below 1.0 suggests it is less volatile. For example, recent reports showed the SPDR Sector Select Tech fund (XLK) having a beta of 1.06, indicating it is 6% more volatile than the S&P 500. Conversely, the SPDR Sector Select Utilities ETF (XLU) has a beta of 0.36, suggesting it is 64% less volatile than the market. Understanding these metrics can help investors and financial advisors tailor investment strategies to match risk tolerance and financial goals.
Systematic Risk vs. Unsystematic Risk
Recognizing different types of risk is crucial for developing an effective investment strategy aligned with your financial goals. Risk tolerance varies among investors, and recognizing the distinction between systematic and unsystematic risk is key to managing your portfolio effectively.
Systematic Risk
Also known as market risk, systematic risk is an inherent part of investing in the stock market. It affects all investments and cannot be eliminated through diversification. Examples of systematic risk include economic recessions, pandemics like COVID-19, or major financial crises such as the 2008 housing crash. These events impact the entire market, regardless of sector or asset class. A financial advisor would emphasize that systematic risk is the trade-off for potentially higher returns compared to low-risk investments like CDs or Treasury bonds.
Unsystematic Risk
Unsystematic risk is specific to individual investments and is unique to aspects of a specific investment, including the risk of an individual company, currency risk in foreign investments, sector-specific risk, etc. This type of financial risk can be mitigated through proper diversification in your investment strategy. For instance, a decline in oil prices might severely impact energy companies but have little effect on tech giants like Amazon or retailers like Walmart. Similarly, the bankruptcy of a department store chain would likely not influence the performance of a streaming service’s stock. It is important to note that diversification does not guarantee against investment loss nor ensure investment gain.
Focus on What Matters: Focus on The Big Picture of Market Volatility:
While there are numerous ways to measure volatility and risk, it’s essential not to lose sight of your long-term financial goals. A well-crafted investment strategy, developed within a holistic financial plan and the guidance of a financial advisor, should be designed to both consider and weather short-term market fluctuations.
When focusing on the big picture of your investment strategy, it’s important to remember that the financial risk that matters most is the potential of not achieving your financial goals. Rather than worrying over daily market movements or spending hours pondering how the news or political cycle might impact your portfolio, you’re better off periodically reassessing your risk tolerance and ensuring your investment strategy remains aligned with your financial goals. This approach to financial planning acknowledges that while market volatility is inevitable, it doesn’t necessarily translate to long-term risk for a patient investor with a well-structured portfolio.
By focusing on your overall financial plan and regularly reviewing your investment strategy with a financial advisor, you can more confidently navigate market ups and downs and stay on track when pursuing your long-term financial goals.
Assess Market Volatility and Risk: Work with an Experienced Financial Advisor
Navigating market volatility and understanding financial risk can be challenging. Working with an experienced financial advisor can help ensure your investment strategy aligns with your financial goals and risk tolerance. Schedule a consultation with Josh Strange, a CERTIFIED FINANCIAL PLANNER™ practitioner or a member of the Good Life Financial Advisors of NOVA team, today for insight and guidance tailored to your unique financial situation.
