Volatility - Understanding the ups and downs of investing

Volatility is a feature of virtually any investment type, meaning the journey towards your long-term financial objectives is likely to contain ups and downs along the way. Here we take a closer look at volatility, the importance of time and the power of diversification. 

Investing in anything other than cash is a medium to long-term commitment – that means at least 3-5 years – but considering that an average economic/market cycle takes around 7 years to fluctuate between growth and recession before coming full circle, perhaps that’s a more reasonable timescale. But why does time matter?

First, it usually takes time for an investment to come to fruition. If you buy shares in a company on the basis that it looks well placed to prosper in the future, then it’s logical that it’ll take time for that potential to be realised. After all, very few businesses are an overnight success.

Volatility – a normal feature

There’s another reason for taking a long-term perspective – something called volatility. Look at a chart of the UK stock market’s performance over 10 years – the trend is upwards and had you invested at the start of 2010 the chances are you’d have made decent gains along the way. Over shorter periods though, the market has experienced more pronounced ups and downs.

In simple terms, volatility is a measure of the size of short-term changes in the value of an investment.

UK stock market’s performance over 10 years

Past performance should not be seen as an indication of future performance.

In simple terms, volatility is a measure of the size of short-term changes in the value of an investment. Volatility is a feature of virtually all investment options and whilst the long-term outcome may be a positive one in terms of returns, the journey is likely to be one that contains ups and downs along the way.

There are no guarantees of course, and volatility may mean that you may not get back the original amount invested when you decide to withdraw your investment.

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Past performance is not a guide to future performance. The value of all stock market investments can go down as well as up and you may not get back the full amount originally invested. 

The power of perseverance

Time is importance because a longer time period smooths out the influence of volatility. 

Episodes of volatility triggered by a variety of factors can be significant. In the bar chart below we look at the performance of UK shares in calendar years between 1986 and 2019. 24 of the 34 years have seen positive returns, but there are years in which shares have fallen sharply. The message is clear – had you invested for an extended period, the chances are that years of positive returns will outweigh periods of disappointment.

There’s even more stark evidence of volatility within calendar year performances. 26 of the last 34 years have seen large falls in the market during some part of the year. However, in more than half of these 26 years, the market has regained its poise and finished the year in positive territory. Volatility is a clear feature of investment in UK equities, but time and again it has paid dividends to put short-term fluctuations in context and focus on the timescale that really matters – the long-term one.

The merits of ‘time in the market’ are readily apparent – participate in the long-term potential of investing and you have more of a chance of riding out the fluctuations that happen along the way.

FTSE All-Share intra-year declines vs. calendar year returns

Source: BMO Global Asset Management. Returns shown are price returns in GBP. Intra-year declines refer to the largest peak to low within a calendar year, as at 31-Dec-19.

Time not timing

But is it possible to time the market? Investment ‘nirvana’ would be the ability to invest during the periods when prices were trending upwards whilst avoiding times when there’s a downward correction.

20 years – the impact of missing the 10 best days

In the absence of a crystal ball it seems an unlikely ambition, particularly when you consider some of the unpredictable factors that can affect markets – how many predicted the global financial crisis in 2008 or the tech bubble busting earlier that decade? more recently we’ve seen markets swing sharply in the short-term after a US Presidential tweet – the timing and content of which are nigh on impossible to foresee! Trying to beat the market by taking short-term positions to avoid losses is unlikely to be a successful strategy and the flip side is the cost of potentially missing out on the days when markets do rise strongly. Just look at the difference in the investment outcome had you missed out n the 10 days in which the market performed the strongest.

FTSE All-Share

Source: Lipper, as at 31-Dec-19, sterling, total return.

S&P 500

Source: Lipper, as at 31-Dec-19, sterling, total return.

Past performance should not be seen as an indication of future performance. 

Back to basics - diversification matters

So, volatility is part and parcel of investment and given enough times its effect can prove to be relatively limited.

It can, however make sense to consider ways of countering the impact and extent of short-term moves. Ahead of realising an investment for example, significant downward fluctuations in value would obviously be unwelcome. Similarly, specific financial circumstances can make individuals more or less accepting of volatility.

Diversification is a proven principle for generating returns in a more consistent and reliable manner. It’s a simple concept: asset classes (like equities, bonds and property) have different characteristics so by spreading your investments across a number of them it’s possible to participate in a broad range of opportunities whilst smoothing out extremes in terms of positive and negative performance.

In this chart the performance of asset types can be seen to vary markedly from year to year – a top performer can see its fortunes swiftly reversed in the following 12 months. Holding a blend of assets, however, can be shown to limit extremes of performance – an approach that can result in a smoother journey towards the investment outcome you’re trying to achieve. The data below reveals that a portfolio invested in equal amounts of the different asset classes would have produced an average annual return of 6.71%.

Pin the tail on the donkey – asset class performance varies year on year 

Source: Lipper, as at 31-Dec-19. IA = Investment Association

Holding a blend of assets, however, can be seen to limit extremes of performance – an approach that can result in a smoother journey towards the investment outcome you’re trying to achieve.

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Glossary

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*Source: Lipper to 31 January 2020, total return. Indices rebased to zero at 31 December 2019.

Views and opinions have been arrived at by BMO and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

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