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Why you should care about volatility (but not too much)

portfolio

Editor’s note: This is an updated version of a story that first ran in 2014.

Many stocks that are prone to sudden gains are just as liable to fall rapidly.

That’s the basic idea behind volatility, which is the difference between the highest and lowest prices of any given security. The higher a stock’s volatility, the riskier it is to own. That’s because you could lose money more quickly than you would with other investments. The reverse is also true—the price of the security could also rise more quickly.

A volatile stock might behave like someone who’s had too much to drink—swerving unpredictably as he walks home. Similarly, a high-volatility stock’s price often moves uncontrollably and irrationally.

A low-volatility stock, on the other hand, would behave like a sober person, travelling in a relatively straight line and only deviating for normal reasons (to pick up milk, for instance). Similarly, this type of stock’s price would usually move rationally, in line with changes in the company’s intrinsic value.

It’s difficult to predict how volatility will impact the price of a particular security. It’s also difficult to predict when markets will be hit by greater volatility. “Market volatility tends to come in a sudden and quick spike,” explains Peter Christoffersen, TMX Chair in Capital Markets at the Rotman School of Management, University of Toronto. “And those spikes are often driven by things we don’t expect, such as political events or sudden changes in oil prices.”

Volatility also tends to arrive more suddenly than it departs, he says. “While volatility hits the market in a sudden spike, it often recedes very slowly,” Christoffersen explains.

No one can predict which events will move markets and how. But one way to gauge market volatility is through the Chicago Board Options Exchange Volatility Index (the VIX), also referred to as the fear gauge. The VIX tracks the prices of options, which are contracts that give investors the right to buy or sell securities on specific dates, at specific prices. These contracts become cheaper or more expensive based on how sure people are that they’ll use them: when volatility is low, investors purchase fewer put options to protect against losses and the price of those options drops.

In short, the VIX gauges how investors feel about the broad market today and how they might feel about it in the future.

A VIX reading of more than 30 typically means the market is volatile. In times of extreme uncertainty, it can go even higher—in 2008, the VIX was over 80. In contrast, a value of less than 20 indicates a more stable market.

Volatility and your investments

Stocks do better than bonds in times of low volatility—but higher volatility is great for bonds, which typically have relatively higher returns during a volatile market, notes Christoffersen. During periods of high volatility, the value of bonds doesn’t fluctuate as much as the value of equities. That’s because fixed-income returns are affected by longer-term trends such as interest rate changes.

During times of higher volatility, you can also look to other investments such as real estate investment trusts (REITs), infrastructure or private equity funds to steady your portfolio. There are also many “low volatility” funds that aim to outperform during times of higher volatility by choosing stocks that perform well in choppy markets (for instance, utilities and consumer staples).

Volatility and you

So should volatility keep you awake at night? No, says Keir Clark, portfolio manager and director of wealth management with ScotiaMcLeod in Fredericton. Volatility creates opportunities for patient investors “who [can] tolerate uncomfortable times and rebalance at difficult moments,” he explains.

It may be best to hold on to your investments. Why? “If you priced your house daily based on what it would sell for any given day, you would see volatility,” Clark says. “But over time the value usually goes up.” Day-to-day volatility doesn’t mean you should dump your investment.

You should ask your advisor how your portfolio would likely behave in volatile conditions. “You need to be comfortable with the mix of stocks and bonds in your portfolio,” Christoffersen says. “The more equities it has, the more volatility it has,” while bonds help smooth out performance. In the long run, people with more stocks in their portfolio have higher returns, but they have to be able to live with the volatility.

Clark picks blue chip stocks, which tend to have consistent performance. While they might underperform when markets are racing ahead, they do better when markets are falling, he says.

What now?

Both Clark and Christoffersen say investors need to gird themselves for more volatility than we’ve experienced in the last few years. Canada’s and America’s central banks have reversed their quantitative easing programs, which propelled stock prices for years, and they’re now raising rates.

“We’ve had few sets of volatility until early this year,” says Clark. He identifies several volatility triggers: interest rates, the brittle NAFTA negotiations and headline risk. Headline risk is defined as “any shocking headline,” he says, such as Donald Trump’s March tweet threatening to slap 25% tariffs on foreign steel and 10% on aluminum (and the subsequent reactions).

Clark also points to the recent rise of electronic, quantitative-based trading, which can cause large, sudden swings in volume. “If there’s a price momentum change that moves by a certain percentage, then the computer program says ‘Sell all this and reduce the position by 75%.’”

He suggests today’s portfolios hold too many equities and not enough bonds. Normally, adds Christoffersen, an investor would re-allocate her portfolio in such a situation, but “interest rates will continue to go up over the next year, so bonds are not such an obvious alternative.” He also warns against increasing cash since he expects inflation to rise, which lowers the real value of a dollar. So, where to put your money?

“When inflation goes up, you want to buy real assets, not nominal assets like nominal bonds,” says Christoffersen. “Real-return bonds give you inflation protection, but you have to accept a very low return.” That leaves stocks, he says. Conventional risk/reward wisdom would make you think that high-volatility equities pay better returns than their lower-volatility counterparts, but Christoffersen expects the opposite. Citing studies, he says high-volatility stocks “could do worse than stocks with low volatility.”

Whatever the strategy, Clark says it’s a good idea to prepare for the impacts of higher volatility by confirming your existing portfolio meets your goals and objectives. He suggests doing this exercise during a quiet or calm time, such as just before summer vacation or during a market lull.

He compares this exercise to a lifeboat drill at the start of an ocean cruise: when “things are still good, everybody’s happy and thinking straight.”