Mitigating the Financial and Emotional Impact of Market VolatilityLearn more about this firm
- The era of low volatility may be over, but the need to pursue long-term financial goals is not.
- Investors should consider both the financial and emotional impact of market volatility.
- Positive returns are achievable in a volatile environment with the appropriate investment strategy.
In the wake of the great financial crisis, an improving economy and unprecedented monetary policy bolstered asset prices and suppressed market volatility. Many who benefitted from this trend assumed that it would continue indefinitely. However, that assumption was shattered by the recent turbulence across global financial markets. We believe the era of low volatility may be over as the markets digest several key issues:
- Divergence in central bank policy as the U.S. Federal Reserve has embarked upon a tightening cycle while other global central banks remain accommodative
- A recognition that we are in a slower global growth environment based on demographic trends and China’s transitioning from an investment-led to a consumption-led economy
- A dramatic oil price shock and the potential geopolitical risks that it brings
As we prepare for an environment of potentially higher volatility, it’s important to consider both the financial and emotional impact to investors. Let’s look at an example of each.
Exhibit 1 presents three hypothetical portfolios, each with the same $100,000 starting amount and the same simple average annual return of 5%. However, you will notice that the ending value of each portfolio is very different. Why? Because the volatility of the returns matters. If their portfolios were able to deliver more consistent returns with less variability, then investors would be better positioned to reach their desired outcomes.
Beyond the potential financial impact, volatility can also be an emotional hurdle. History has shown that investors often make emotional investment decisions during periods of significant market volatility — buying as markets rise and selling as markets decline (Exhibit 2). For investors with long-term wealth accumulation goals, simply participating in the upside of markets isn’t enough. The potential impact of the downside is a critical consideration. Investment strategies that seek to generate more consistent returns and less severe drawdowns may offer investors a higher likelihood of maintaining their investment plan.
Past performance does not guarantee future results. It is not possible to invest directly in an index.
Sources: Morningstar Direct and Columbia Management Investment Advisers, LLC. Equity net mutual fund flows represented by 12-month trailing equity net mutual fund flows (international and U.S. equity). Global equity index represented by MSCI ACWI Index. As of December 31, 2015.
This year has clearly gotten off to a difficult start. Our base case for 2016, which we outlined in the latest Investment Strategy Outlook, is a continuation of the environment of 2015 — lower returns and higher volatility. We strongly believe, though, that positive returns are achievable, even in this new environment, with the appropriate investment strategy.
To help ease the impact of volatile markets, we encourage investors to consider risk allocation and alternative investment strategies, both of which may offer enhanced diversification benefits. In addition, embracing flexibility through tactical and dynamic reallocation may provide return opportunities while helping to mitigate loss if market conditions were to worsen.
Louisa May Alcott once wrote, “I’m not afraid of storms, for I am learning how to sail my ship.” Volatility is a natural part of investing. Investors who are able to navigate both the financial and emotional hurdles that come with market volatility may stand a better chance of reaching their long-term financial goals.