Unpredictable Change Over Time
Volatility refers to the degree of unpredictable change over time. To an investor, this generally means the potential range of returns around an expected or average return. Because volatility looks at unpredictable change, it is used to measure risk. The more volatile the price of the asset, the riskier the asset will be to invest in. Taken one step further, the riskier the asset the greater potential for unexpected gains and the greater potential for unexpected losses. The relationship between higher risk and higher potential return is often referred to as the risk-return trade-off. In exchange for higher potential returns, an investor needs to take on greater risk and vice versa.
Volatility also acts as an indicator of investor sentiment. When investors are more uncertain about the future, they become nervous. Higher levels of return are required in order to compensate for the increased risk. In general, high levels of volatility indicate investor nervousness, while low volatility signals a stronger appetite for risk.
When there is uncertainty in the markets, many investors sell what they can and move to cash as a safe haven. This causes markets to fall. As soon as some good news comes out, the herd rushes back in to buy assets at what is perceived as a bargain until the next piece of negative news arrives and the herd shifts direction once again.
Periods of volatility tend to be driven by short term trends when investors lose focus of long term goals.
These periods are a good time to step back and revisit your long term goals, risk tolerance and investment strategy. The insurance company that administers your retirement savings plan offers tools to assist you with this. As well, you should seek the advice of a qualified advisor if you have any questions or concerns. If your goals and risk tolerance are still valid, the market dips might offer an attractive buying opportunity. An effective way to keep focused on long term goals is to ensure you are making regular contributions and averaging out the market’s ups and downs.