Understanding how it works can help you make more informed decisions, potentially manage risks more effectively, and optimize potential returns.
Here's our guide on how to navigate market volatility.
The Risks of a Volatile Market
Before we get into how to successfully navigate volatility, let’s look at some of the main risks that a volatile market poses to investors.
Capital loss
Arguably, the potential for substantial losses is one of the most direct risks of market volatility.
As an investor, you may witness the value of your portfolio decline rapidly during a volatile period. If you choose to sell your investments when prices are down—for example, due to a sudden need for cash because of a medical emergency or job loss— you stand to incur significant losses.
That’s why some experts recommend that you build a sufficient emergency fund before you start investing. It can provide a financial cushion, potentially helping to minimize the need to liquidate your investments under unfavorable conditions.
Liquidity risk
Liquidity risk refers to the possibility that investors will be unable to purchase or sell assets quickly enough at a desired price due to a lack of counterparties in the market.
Let’s say you’ve invested in a certain company, but your research reveals its fundamentals—the factors that contribute to its value and health, such as earnings, cash flow, and competitive environment—have taken a negative turn. As a result, you no longer believe in its long-term potential.
Naturally, you’d want to divest and seek greener investment pastures. However, limited market liquidity could stop you from selling the asset quickly, exacerbating your losses if the market moves against you even further.
Conversely, spotting a great deal but not being able to buy it in time due to liquidity constraints can rob you of prospective lucrative returns.
Broad market value declines
Different asset classes (like stocks, bonds, commodities, and currencies) and sectors typically behave or react differently to different economic factors or events.
However, during intense market volatility, widespread negative investor sentiment can cause almost all asset classes and sectors to trend downwards collectively. Even those asset classes or sectors that are typically stable or consistently perform well might suffer in these conditions.
Say you're an investor who’s put a lot of time and effort into picking a mix of investments you believe are solid. Unfortunately, when broad market declines happen, even your carefully chosen and well-balanced portfolio can experience losses.
This serves as a stark reminder that, though investing can be a good way to build and accumulate wealth, it's still inherently risky.
Herd mentality
In volatile markets, herd mentality—i.e., when investors follow the crowd without conducting their own research and analysis or considering the long-term implications—can exacerbate price swings.
If a majority of investors begin selling a particular asset out of fear or speculation, others might follow suit. This creates a snowball effect and results in prices declining faster than they otherwise would.
On the flip side, if there’s a sudden surge of interest in a certain asset and everyone starts buying it, prices can shoot up very fast. Such frenzied activity leads to a bubble. When the bubble inevitably bursts, it can deal a severe financial blow to investors.
Macro-economic consequences
Prolonged market volatility can have broader economic repercussions. For example, it can reduce consumer and business confidence in the economy, leading to decreased spending and investment. This can slow economic growth and potentially result in recessions.
Governments might adjust interest rates in response, which can further sway asset valuations. For example, when interest rates go up, bond prices tend to go downwards.
Deterrence to new investors
Heightened volatility can intimidate prospective investors, discouraging them from taking their first steps in the market. They might think, "This is too risky. Maybe I should hold on to my money rather than invest it."
When many newcomers feel this way, the market misses out on fresh money coming in. This lack of new capital inflow can slow things down in the trading arena. For existing investors, this can translate to reduced liquidity, making it more challenging to execute trades.
Emotional decision-making
Market volatility can incite strong emotions, predominantly greed, fear, and panic.
When markets are rising quickly, greed can push investors to buy without proper research, which could lead to them entering the market at its peak.
Conversely, when markets fall sharply, fear and panic can drive investors to sell their assets prematurely, even if the fundamentals are still sound.
Essentially, in volatile markets, emotional reactions can lead to a buy-high, sell-low pattern among investors, which often has detrimental effects on long-term success.
How to Deal with Market Volatility
As we’ve seen, volatile markets present numerous risks to investors. So how can you successfully navigate this phenomenon and put yourself in the best position for success?
Here are a few useful strategies.
1. Practice diversification
At its core, diversification is an embodiment of the old adage about not putting all your eggs in one basket.
It means spreading your investments across different companies, asset classes (like stocks, bonds, real estate, and commodities), sectors or industries (such as technology, manufacturing, and healthcare), and global regions (North America, Europe, Asia, and so on).
No investment is entirely risk-free, but by diversifying, you reduce the likelihood of your whole portfolio plummeting or experiencing catastrophic losses due to adverse movements in any one asset class, sector, or region.
Diversification works the majority of the time because as alluded to earlier, different asset classes, sectors, or regions rarely have the same reaction to major economic and market events.
While some sectors or asset classes might be declining, others might be rising (or at the very least holding steady), providing a counter-balancing effect. For example, during a period when stocks might be declining, commodities or bonds might be rallying, and vice versa.
Similarly, global markets rarely move in sync. Diversifying geographically allows you to capitalize on growth in one region even if another is in a slump.
In essence, diversification offers a safety net in the face of intense market volatility, ensuring that even if one section of your portfolio underperforms, other areas can potentially compensate for those losses.
2. Focus on the long term
It’s natural to feel anxious when you see your portfolio's value swing. Adopting a long-term perspective can help you power through such times. A long-term mindset means resisting the urge to react to every market fluctuation and sticking to your investment strategy.
The key thing to remember is that investing is a marathon, not a sprint. History shows that while the market may experience numerous ups and downs, its general trajectory over the long term is upward.
Indeed, short-term fluctuations become less significant when you’re focused on a horizon spanning years or even decades. A stock market dip this month or this quarter will seem a mere blip when assessed against an investment span of five to ten years.
If you’re struggling to keep your eyes on the big picture, just consider how similar market cycles have unfolded in the past. From the dot-com bubble burst (2000–2002) to the financial crisis of 2007–2009 to the COVID-19 dip in 2020, the markets have always rallied from periods of intense volatility to set new record highs.
3. Treat volatility as an opportunity
Instead of seeing market volatility as a bad thing, flip the script and consider it an opportunity.
Market volatility poses many risks, but it also comes with one silver lining—a chance to invest at reduced prices.
Let’s say there's a stock or investment you've had on your radar, but it's remained elusive due to its consistently high price. A sudden market downturn could be your chance to invest in this stock at a discount and add it to your portfolio.
Similarly, if you’ve already invested in a certain company whose fundamentals predict a bright future for it, a market downturn may be a good time to buy additional shares at a lower rate.
Although positive returns are never guaranteed, by expanding your portfolio during downturns, you can be setting yourself up nicely for decent returns when the markets rebound.
Here’s a powerful example: if you had bought an S&P 500 index fund in March 2020 during the onset of the COVID pandemic—when stock markets hit record lows and many assets were selling at bargain prices— your investment would have been up more than 65% by the end of the year!
By adopting this forward-thinking strategy, you can transform volatility into a stepping stone rather than a stumbling block, edging you closer to your financial goals.
4. Stay informed and educate yourself
Rather than focusing on the ups and downs of the market, use this time to educate yourself and deepen your understanding of the investments you hold, the broader market in general, and economic trends.
Knowledge is a powerful ally during periods of market volatility. It grants you the clarity to sift through the noise and focus on what truly matters.
Armed with adequate information and perspective, your decisions become anchored in logic and reason rather than emotions. You can effectively dissect market movements and discern between short-term fluctuations and long-term shifts in value.
Take, for instance, a company in your portfolio that's currently facing a price setback. If you’re well-versed in its history, financial health, and long-term value proposition, you can assess whether this dip is a transient hiccup or a reflection of a deeper issue that affects its long-term potential.
Any choice you make about the company, therefore, becomes rooted in informed analysis rather than speculation or fear.
5. Talk to a professional
Talking to a professional, like a licensed financial adviser, can be extremely useful in the face of high market volatility.
One of the primary benefits is emotional grounding. In turbulent times, it’s easy for investors to be overwhelmed with emotions. Professional advisors can soothe your concerns by offering clarity and perspective about the present status of your portfolio.
They bring a wealth of experience to the table, having likely navigated various market conditions and assisted many clients in your position. They can help you see the importance of having a long-term view and sticking to your investment strategy.
Consulting with a professional can also provide an opportunity to reassess and potentially readjust your investment approach.
For instance, during your discussions, you might discover that your portfolio isn’t as diversified as it should be for maximum risk mitigation. With professional guidance, you can restructure your investments to work towards better protecting against unfavorable market swings in the future.
Conclusion
Staying calm and maintaining a disciplined approach can be challenging during periods of intense market volatility. Yet, your ability to do is can make a difference in the long-term results of your investments.
Separating emotions and investments is a critical step towards making more objective decisions.
If you've weathered volatile markets before, use that experience to guide you through a stormy season. If you're new to the investment world, you can lean on the historical resilience of markets and their consistent ability to bounce back.