Ken Roberts: Understanding volatility cycles
October 21, 2014
Many investors focus on long term returns when making their investment decisions. There's nothing wrong with studying historical rates of return and using that information to help decide which mix of assets is right for you.
Another factor worth evaluating is the historical volatility of the assets you are considering in addition to the return. Historical volatility is measured using standard deviation and is fairly easy to obtain.
The reason that volatility should be one of your considerations is because you should be comfortable with your investment portfolio, and if it's too volatile, it could cause some real stress, even if the long term returns are satisfactory.
If wild swings in the stock market are keeping you up at night, your portfolio might be a little too volatile for your comfort level.
I've written about market volatility cycles in the past — they are known as "regime change." The market has always gone through periods of high and low volatility. The market tends to spend over 80 percent of the time in a low volatility mode, rising steadily, followed by periods of high volatility and falling prices.
The periods of high volatility tend to quiet down eventually and the market returns to the normal low volatility. Price swings can be dramatic during the high volatility periods.
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If you're looking at an investment, whether it's a stock or a mutual fund, check out its historical volatility and see if holding that investment is something you'd be comfortable with.
It's possible to build a portfolio of low volatility stocks if large price swings make you uncomfortable. It's also very important to remember that using historical volatility is a study of past price movement, and with equity investments, of course there is no guarantee that the same volatility will continue into the future.
A stock that has had a long history of low volatility could fall out of favor and become volatile. Mutual funds that represent broad based indexes like the S&P 500 will become volatile at times.
There always has been and there always will be some volatility in stock prices. Knowing the past volatility of investments can help with your decision making process.
Money invested in the stock market should have a long term time horizon, and investors should be prepared to ride out some periods of high volatility and dramatic price swings, and should also strive to construct a portfolio that they'll be comfortable with over the long haul.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.