Over the last 2 years, a common theme of the markets has been volatility. So far, the start of 2022 has continued that theme. While it is not a fun topic to discuss, it is important to understand volatility and the role it plays in a portfolio.
In its most basic form, market volatility is the fluctuation of asset prices both up and down. This fluctuation is driven by uncertainty both in the market as a whole, and in individual assets or sectors.
Volatility has four main causes:
1. Market Risk – this is the most common culprit as it impacts the whole market. Common examples are interest rate changes, natural disasters, and political tensions.
2. Liquidity risk – This is the risk that an investor cannot sell an asset because there are no buyers.
3. Credit risk – This is the risk that debtors will default on their payments to creditors.
4. Operational Risk – This is the risk involved in the operations of a company, such as poor management, fraud, or other activities.
While it is impossible to completely eliminate volatility due to market risk, effective asset allocation and diversification can help minimize the effects caused by company or sector specific risks. Different asset classes carry different levels of volatility.
For example, a small company’s stock price will vary more than a large company’s as its business has more uncertainty. It has the potential to lose more than the large company’s stock, but the small company’s stock also has the potential to gain more.
A portfolio will incorporate a bit of every asset class to capture the growth of the riskier investments while the relative safety of the less volatile investments helps offset the losses of those riskier asset classes. Working with an advisor can help aid in construction for advisory accounts as he or she would build a portfolio tailored to the individual investor’s goals and comfort level.
Market volatility can create some opportunities, such as tax loss harvesting and strategic buys.
Tax loss harvesting is a practice in which an investor sells an asset for less than he or she purchased it. Though this may go against the “buy low, sell high” mantra, it can be beneficial in some circumstances.
In a taxable account, the loss can help offset some of the gains. This frees up some capital to purchase new assets or rebalance the portfolio with minimal tax implications.
In addition, higher volatility can create some good buying opportunities. While this may seem counterintuitive, an investor could purchase a once expensive asset at a more modest valuation if prices decline.
Discipline & Perspective
Arguably, the two most important factors to weathering market volatility are the discipline to stay invested and having a long-term perspective.
Over its history, the market has proven to be resilient, trending up over time despite its challenges, such as the Great Recession or the COVID-19 pandemic.
It can be difficult in the short term to watch the fluctuations in one’s account, but often the worst days in the market occur around the best days.
For example, if an investor missed the 20 best days over the past 15 years, their annualized return would be 0.1%. By comparison, if they stayed invested over that entire span of time, their annualized return would be 6.6%.
If an investor is working with an advisor, their financial plan is carefully constructed to account for the investor’s goals and risk tolerance as well as market volatility.
Source: FactSet Data as of 8/31/21
Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation. The information contained herein has been obtained from sources considered reliable, but we do not guarantee that the foregoing material is accurate or complete. This material is strictly for informational purposes only and is not a recommendation of any kind. Raymond James does not offer tax advice. Raymond James is not affiliated with any other entity listed herein. 2022 Raymond James Financial Services, Inc., Member FINRA/SIPC.
