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Understanding Market Volatility

Market VolatilityUnderstanding Market Volatility

Volatility in the share market is both a threat and an opportunity. It is a threat for people who don’t understand it and an opportunity for those who do. It is something to be welcomed. Without volatility there would be no capital gain. There is a natural process at play in market cycles called ‘reversion to mean’. Simply put, this means that share prices follow a long term upward trend, around which prices will be higher or lower in the short term, but will always head back toward the trend. When prices get too high or too low, there will be a trigger which points them back in the direction of the trend. Market cycles can take some years to play out, and investors who have spent a long time in the market have a greater understanding of this principle and how it works. The more crises an investor has successfully lived through, the easier it is to put emotion aside and resist panic.

The reversion to mean principle relies on diversification to work well. A diversified portfolio will broadly track the movement of the market as a whole. Investment risk will then change from a risk of loss to a time risk, providing funds remain invested. A diversified portfolio will always regain any value lost; the only uncertainty is how long it will take to do so. This is why the time frame for investment is such an important part of investment strategy. If funds are needed in the short term for another purpose, there is a risk that investments will need to be sold at a loss, before they have had time to recover their value. A well-considered strategy takes investment time frames into account. Short term volatility shouldn’t alter the strategy for achieving a long term goal.

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Focus on the Horizon

Focus on the Horizon

When I was young, I used to go fishing with my father in his boat. Not being much of a sailor, I often succumbed to the motion of the waves when there was a big swell. All I wanted to do then was to get my feet back on firm ground. I still remember the advice my father gave me to help me last the distance back to land. He would tell me to focus my eyes on the distant horizon. By looking at a steady point far away, the ups and downs became tolerable and, after plenty of practice, I didn’t even notice the movement. Now, as an investor, I find I can use the same technique when markets become volatile. The horizon on which I must stay focussed is my ultimate investment goal and if there is no good reason to change it, then the short term ups and downs should make no difference to my investment strategy.

 Markets move in cycles and as surely as the sun will rise every morning, markets that have dropped will rise again. The value of a diversified investment portfolio will move in waves that fluctuate within a band on either side of a long term trend line; never reaching either infinity or zero.

 Share prices are driven by two major forces; market sentiment (fear and greed) and market fundamentals (economic and financial performance). Market fundamentals set the upper and lower limits of value, while market sentiment is the driving force between the upper and lower limits. When the market drops, it is time to look for bargains. There are opportunities to make long term gains by investing in markets and companies that have solid economic and financial prospects, and which will experience a rise in price when the market sentiment changes.

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Use Market Volatility to Make Money

Investment Markets

Investment markets move in cycles and it’s difficult to forecast when they’ll rise or fall. Moving your money in and out of the market during a downturn means you could potentially miss out on any positive bounce in a strong market recovery. Market volatility is what generates the return on your investment, and you can therefore use volatility to make money. With experience we find that most events in life that are volatile or uncertain still follow a reasonably predictable pattern over time. In financial markets, making observations about the way markets have behaved previously in similar conditions should enable you to take the right actions and to reasonably predict the outcome.

Markets move in cycles and as surely as the sun will rise every morning, markets that have dropped will rise again. The question is, how far will they drop in any downturn and how long will it take before they start to rise?

When markets are uncertain in the short term, there are some important principles to consider before you invest. More than ever, the two key principles of liquidity and diversification apply. In simple terms, that means you should aim to invest in things that can easily be converted to cash again (don’t put your money into investments that are locked in or for which there are few buyers and sellers) and spread your money among many different investments rather than trying to pick winners. One of the most effective ways of achieving this is to use another basic investment principle, called dollar cost averaging. That simply means drip feeding small amounts of money on a regular basis into a diversified investment. 

For long term investors, short term market volatility will seem of little consequence in years to come.

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