The impact of the turmoil in Greece on share markets is a classic example of how the emotions of fear and greed create volatility. When shares start to drop in value, investors can become fearful of sustaining further losses. This leads to panic selling which further fuels the fear. Eventually a turning point is reached where less risk averse investors spot the potential for gain. Increased buying activity pushes prices up, and fear is allayed. The outcome of this process is that risk averse investors suffer losses while gains go to those who are less risk averse.
Significant events can have a ripple effect on markets, just like a pebble being thrown into water. High levels of uncertainty create high volatility, and as the outcome becomes clearer, the uncertainty and volatility gradually decrease. Volatility is a test of true levels of risk aversion. It is easy to be a confident investor with a high exposure to growth assets when volatility is low and returns are high. Falling prices quickly reveal attitudes to risk. They also reveal insecurities formed from previous episodes of volatility. Memories of events such as the Global Financial Crisis can create irrational fear.
Diversification is one of the principal tools for reducing risk. The risk of investing in a portfolio with an adequate level of diversification is not a risk of loss but a time risk – that is, how long the investor has to remain invested in order for value to be restored and for the investor to be rewarded with a rate of return over the investment period which reflects the degree of risk taken. Volatility is a reminder that investment in growth assets is a long term game. If long term goals and strategies have not altered, short term volatility should be of little concern.