What is Volatility?
Volatility is a measure of market risk based on the fluctuation of returns in response to external factors, both negative and positive. For instance, economic surprises, geopolitical events and even investor sentiment can cause sharp market movements either up or down. Volatility is typically represented by standard deviation, which measures the variance in the average returns of a specific market or investment over time. Less variance of returns means lower volatility and therefore lower risk.
Volatility Is on the Rise
The past few years have seen increased volatility in the financial markets. For instance, average volatility (standard deviation) of the S&P 500 Index during the 1990s was 13.66% but increased to 18.02% since 20001.
The chart below illustrates this trend, with a relatively smooth upward curve through the 1990s but significant swings up and down since about the year 2000.
Investors Have Paid the Price
Often, a byproduct of volatile markets is significant downturns, which require even larger recoveries. For instance, after a 40% decrease, you need an investment to increase nearly 70% in order to return to where you started.
In addition, market volatility, similar to a roller-coaster ride, can cause extreme anxiety for many investors. When sentiment is low, emotions can drive investment decisions, which often results in underperformance. Frequently, market sentiment is lowest when the opportunity is strongest. Rather than buying when markets are at their lowest and set to rebound, many investors buy at market highs and sell at market lows, lowering the performance of their portfolios.
Alternatives Can Provide Similar Returns with Less Volatility
Diversification can help lessen portfolio volatility. By using additional sources of income such as alternatives, investors can decrease their reliance on traditional market returns and potentially lessen their overall portfolio risk. It should be noted that diversification strategies do not ensure profits or protect losses in declining markets. In general, alternatives rely less on broad market trends and more on the strength of each specific investment.