Understanding the Impact of Volatility on Equity Investments

Randy Joseph
July 16, 2019

If you’re a long-term investor—that is, your investment horizon is ten years or longer—equities are likely to play a meaningful role in helping you achieve your financial goals. To prepare, it’s important to understand what volatility is, the difference between short-term and long-term volatility, and whether it’s a risk that should concern you.

Is Your Portfolio at Risk?

The phrase “no pain, no gain” expresses the belief that some type of stress or suffering is required to ultimately achieve success. Though it has long been the mantra of athletes and exercise fanatics, it may also ring true for many investors. So, when it comes to investing, achieving your long-term financial goals also typically requires enduring temporary pain

Investing can be painful for a variety of reasons. You might own an inherently bad investment that ultimately results in a permanent loss of capital. Or, your investment strategy might not be appropriate for your objectives and investment horizon. Both types of pain can be managed and significantly reduced with a structured and disciplined investment process.

The pain that most of us with long-term financial goals cannot avoid is that associated with unexpected short-term and often sharp portfolio losses. Short-term losses are often inevitable for equity investors, since a certain amount of risk (volatility) must be accepted when trying to grow your money. This is a cost of investing.

It’s important to understand what volatility is, the difference between short-term and long-term volatility, and whether it’s a risk that should concern you. However, to understand and accept volatility, it may be helpful to first take a step back and understand why we invest in equities.   

Why Equities?

The reason most people save and invest their money is to prepare themselves financially for a future goal, which may be retiring comfortably, passing wealth on to future generations, leaving a legacy of charitable giving, or simply growing and accumulating wealth. Most financial goals have an associated time horizon and a target growth rate—the average amount your investments need to earn each year for you to meet your goal, given your time horizon. Both play important roles in determining the right investment approach.

Equities have historically earned a premium over bonds to compensate investors for the additional risk associated with owning them. As a result, equities have tended to earn more than bonds over long-time horizons and have done a better job of outpacing inflation.

Short-Term vs. Long-Term Volatility

Investors tend to be less tolerant of short-term volatility—specifically, the sharp investment losses that typically accompany market corrections. By nature, investors are loss averse, meaning we achieve more satisfaction from avoiding a loss than from gaining an equivalent amount. In fact, behavioral scientists have found that the pain of loss is nearly twice as powerful for investors as the pleasure of an equal gain. As a result, many investors are compelled to sell their equity investments and hold cash during market downturns.

Volatility is concerning over shorter periods because it’s during these sudden market declines that nearly all investments may fall in tandem. Years like 2018 are a great example, when it felt like investors had nowhere to hide.

Under more normal circumstances, different types of investments tend to experience their ups and downs at different times. Accordingly, portfolio volatility can be largely reduced over longer periods by diversifying across asset classes and geographies.

Is Volatility Really a Risk?

In the short-term, yes, volatility can be risky. Not only does it create fear in investors that can lead to poor investment decisions, in some cases these poorly timed decisions can prevent you from meeting your goals. After the Great Recession, many hopeful retirees were set back years due to the magnitude of their investment losses.

Years like 2008 demonstrate why time horizon is such a critical component of portfolio construction. Because we know that short-term losses are always possible and likely, understanding our investment horizon allows us to prepare accordingly. As one’s time horizon shortens, they may want to consider reducing equity exposure in favor of more stable assets such as bonds.

If you’re a long-term investor—that is, your investment horizon is ten years or longer—equities are likely to play a more meaningful role in helping you achieve your financial goals. History tells us that short-term volatility is unavoidable, and therefore, you’re bound to experience periods of pain and discomfort along the way.

It’s easy to see why so many investors head for the door as soon as short-term volatility appears. However, abandoning your investment plan during periods of temporary pain is almost never a good idea. Investors who let their emotions get the better of them tend to miss a good portion of the subsequent gains that often follow, making achievement of long-term goals more difficult.

Often, the best defense is to stick to the plan you and your wealth advisor have developed. Though you may experience short-term losses, staying the course will help ensure that these losses are only temporary and will ultimately increase your chances of achieving your long-term financial goals.

For more information on current equity markets performance and outlook, check out the latest Financial Market Monitor in our Investment Resources.

Randy Joseph is a relationship manager for CIBC Private Wealth Management with more than 20 years of industry experience. He is responsible for business development and managing existing relationships for high net worth individuals and families. He joined CIBC Private Wealth Management in 2014.