Market volatility can erode a portfolio’s value


Volatility is a measure of market risk based on fluctuation of returns in response to external factors, both negative and positive. Economic surprises, geopolitical events and even investor sentiment can cause sharp market movements 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 means lower volatility and therefore lower risk.

 


Volatility is on the rise

The past few decades have seen increased volatility in the financial markets. For instance, average volatility (standard deviation) of the S&P 500 Index during the 1990s was 13.43% but since 2000 average volatility increased to 14.52%.1

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.

Volatility has been on the rise

Growth of $100,000 in the S&P 500 (1990 - 2017)

Chart: Volatility has been on the rise

Source: Morningstar. Past performance is no guarantee of future results. Returns assume reinvestment of dividends. The information provided is for illustrative purposes only and not meant to represent the performance of any specific investment. The S&P 500 Index is an unmanaged index that consists of the common stock of 500 large-capitalization companies within various industrial sectors, most of which are listed on the New York Stock Exchange. It is not possible to invest directly in an unmanaged index.

Investors have paid the price

One byproduct of volatile markets can be significant downturns, which require even larger recoveries. For instance, after a 40% decrease in an investment’s value, you need an increase of nearly 70% in order to return to where you started.

It can take years to recover from a market downturn

A $500,000 portfolio's recovery from a 40% decline

Chart: It can take years to recover from a market downturn

Like a roller-coaster ride, market volatility can also induce anxiety in many investors. Frequently, market sentiment is lowest when 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, which often results in underperformance.

Alternatives can help lessen
portfolio volatility

By integrating differentiated sources of return, such as alternatives, investors can decrease their reliance on traditional market performance and potentially lessen their overall portfolio risk. It should be noted that diversification strategies do not ensure profits or protect against losses in declining markets. However, in general, alternatives rely less on broad market trends and more on the strength of each specific investment.

Alternatives offered an attractive risk/return tradeoff

Returns and volatility of selected asset classes (1998-2017)

Chart: Alternatives have offered attractive returns with less volatility

Source: Informa Investment Solutions. Investing involves risk. Past performance is no guarantee of future results. Asset categories are represented by the following: bonds, Bloomberg Barclays US Aggregate Bond Index; commodities, Bloomberg Commodity Index; managed futures, HFRI Macro: Systematic Diversified Index; long/short fixed income, HFRI Relative Value Fixed Income Corporate Index; global macro, HFRI Macro Index; long/short equity, HFRI Relative Value Index; market neutral, HFRI Equity Hedge: Equity Market Neutral Index; real estate, NAREIT All Equity REITs Index; stocks, S&P 500 Index. The performance information above is based on annualized quarterly returns from 1998-2017. Volatility is represented by annualized standard deviation. Use of other beginning or ending points, or of a longer or shorter period, would result in different relative performance among the asset classes. Indices of managed products, and hedge funds in particular, have material inherent limitations and should not be used as a basis for investment decisions. It is not possible to invest directly in an unmanaged index.