What is volatility and how does it affect your investments?

Many investors fear the ups and downs of a volatile share market. They can mean lower returns and more risk – but others see them as an opportunity to buy shares more cheaply.

There’s a lot of talk about volatility among experts in the investment world. But what does it mean?

Volatility measures how far and how often share prices move up and down.

Large price movements over a short time are viewed as ‘high volatility’. Small movements mean prices are stable and are viewed as ‘low volatility’.

Volatility can be caused by various factors, but disappointing surprises, political moves, and trade uncertainties are common reasons for dramatic dips in share prices.

One tweet from US President Donald Trump can cause a big reaction in the markets, as people try to guess what it means for the US or the world.

Sometimes when time passes, people realise the news isn’t as bad as they feared. The prices can recover as quickly as they’d dropped. Sometimes it takes longer for them to recover.

Iindexes chart volatility, but the index which most clearly shows how the market thinks the US economy is tracking is the Chicago Board Options Exchange Volatility Index. It’s informally known as the VIX, but some call it by the nickname, the ‘Fear Index’.

The VIX looks at how likely there is to be volatility in the future, by collecting together the prices of options contracts (what buyers have agreed in advance to pay) and their strike prices (what these buyers would sell at) over the S&P 500 Index (SPX).

The VIX spiked to its highest in three years in February this year, after a period of record lows.

When volatility is low, share markets are more stable; and when volatility is high, share markets are shaky and large losses can be made. High volatility means increased risk and, often, reduced returns. However, some investors also like high volatility as it can provide good hunting grounds for shares that temporarily become cheap. We’re currently in a period of volatility – there have been regular blips both up and down for months.

Protecting your portfolio

Investing in the share market means your shares will fall sometimes, although you hope they’ll mainly rise.

Two things can help you protect yourself. You can diversify your portfolio, and also aim to understand your tolerance for risk. 

  • Understand your tolerance for risk. Would you be deeply uncomfortable if your investments were to drop in value? How much of a disaster would it be? Are you about to retire, or buy your first home? Any of these situations mean you might want to pick investments with less risk of losing money.
  • Don’t rely only on shares as a source of wealth. Create a portfolio (a cluster of investments) with a mix of asset classes. Yes, there will be shares in it, but also invest in bonds and cash. Typically, if shares drop in value, bonds and cash don’t (and vice versa). You could also consider property and assets like agriculture or forestry.

Not having all your eggs in one basket reduces risk and your exposure to the impact of volatile markets.

Published August 2018

We aim to make investment with KiwiSaver easy to understand. To help us make this article reader friendly, we used The Write Plain Language Standard.

Pie Funds Management Limited is the issuer of the JUNO KiwiSaver Scheme. You can read our Product Disclosure Statement. This article is general in nature only and has not taken into account any particular person’s objectives or circumstances. We recommend you speak with a financial adviser. All content is correct at time of publication date.