In many cases, whenever we think of volatility we think negatively. Try it yourself. Think of the word volatility and say it out loud. What thoughts, words, or images pop into your head? Bad news? Market losses? Losing money? The color red?
The point is that we tend to give volatility a bad rap – and rightfully so. Generally, the word is thrown at us during periods of when the market, and our investments, lose value. Volatility, however, works both ways. It’s also present when the market and our investments are doing well. We just don’t call it volatility. We call it returns, gains, appreciation, a bull market, etc.
The point is to expect volatility – good or bad. It’s part of investing in capital markets. We need to understand that just because our portfolios are doing well – doesn’t mean volatility is absent. Volatility is what helps produce long-term expected returns. It’s how we’re compensated for investing outside of riskless assets.
However, if volatility – good or bad – has an individual running for the antacids, then it’s generally a good sign that individual shouldn’t be invested in capital markets at all. Or, if an investor has a short-term time frame for a goal, such as an emergency fund or saving for a car or down payment for a house, volatility, while giving the potential for a higher return, also means the potential for losses – something to avoid for short-term goals.
Investors can manage volatility through proper asset allocation and diversification. In other words, investors should expect to lose and gain throughout their investing time-frame. Proper asset allocation and diversification can ensure that an investor experiences the volatility most appropriate for their risk tolerance and time horizon.