Financial markets stumble from time to time, and occasionally they fall. When they do, “volatility” becomes the industry buzzword. Volatility refers to how much and how often asset prices change. For instance, if an investment’s price regularly moves 1-2% each day, it’s considered more volatile than an asset that moves just 0.5% daily. Riskier assets are naturally more volatile. The upside is that higher risk usually brings higher long-term returns. This is a key principle in finance: investors are paid to take risks. If this weren’t true, everyone would simply invest in the asset with the highest expected return.
This is why it’s important to diversify a portfolio across different asset classes. In a well-constructed portfolio, different assets react differently to economic events, which can reduce overall volatility. Nobel Laureate Harry Markowitz famously said, “diversification is the only free lunch in investing.”
Sometimes, it’s not just risky assets that experience volatility. In early August, a weak US jobs report triggered a wave of market volatility. The Nasdaq, a US tech-heavy stock index, dropped nearly 8% in less than a week. Japan’s stock market fell by over 12% in a single day. Yet both markets recovered quickly, and the volatility subsided.
What caused this, and how should an investor react? In a perfect world, investors would sell just before the volatility hits and buy back when prices drop. But timing the market that perfectly is nearly impossible, even for seasoned investors. Monthly jobs reports are frequent, and making a habit of selling assets each time would be both risky and costly. Over time, staying out of the market too much can hurt your portfolio, as markets tend to rise more often than they fall.
In this case, the market had grown overly confident in a stable US economy. The jobs report raised concerns of a slowdown, which led to panic. Markets are still driven by human emotion, and when unexpected events occur, panic often spreads quickly. Investors began to worry about other factors, like risky bets funded by cheap Japanese Yen or overvalued tech stocks. When panic sets in, it can feel tempting to sell everything. Algorithmic trading can amplify this panic, making the market noise even louder.
However, selling during the panic would have been a mistake in early August. In fact, it was a great opportunity to buy more US and Japanese stocks.
What can investors learn from this example, and similar events in the past? First, as an investor, you are paid to take risks. Don’t fear volatility; it’s the reason that assets provide higher returns over time. Sometimes even less risky markets experience volatility, as we saw in August. The key question to ask is whether the market volatility changes your fundamental view of the asset. In most cases, the answer will be no.
Unless something fundamentally changes the value of the asset, it’s usually best to ride out the volatility. Panicked markets often overreact. If you sell during the panic, you may not be able to buy back at a lower price, and you risk missing out when the market recovers. Finally, always have a diversified portfolio. Diversification works because it reduces risk while allowing for long-term returns above cash. This brings us back to the basic point: investors are rewarded for taking risks.
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