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.