Investment commentary April 2017

Why you should know the difference between volatility and risk

On 21 March, the US share market fell by 1.2%. The fall was attributed to President Trump’s difficulty in passing his health care bill through Congress. The thinking apparently being that if he can’t pass a health care bill then his planned tax cuts might also be in jeopardy.

The Australian market fell by 1.6% the following day, and the Financial Review headline was ‘ASX loses $26bn in Trump slump’. That’s a big number, and a catchy line, but the remarkable thing isn’t that the shares fell, it’s that the market has been unusually calm lately. In fact, that was the first time the US share market had fallen by more than 1% in 111 days. To beat that stretch you’d have to go all the way back to 1966 when Lyndon Johnson was in the White House.

So what’s a normal level of market movement?

Over the long term we’d expect the share market to experience a one-day fall of greater than 1% around once every two weeks. There’s not always an obvious reason for the fall, just as there’s not necessarily any particular reason why shares go up on a given day. These short-term movements in prices are called volatility.

Volatility tends to increase when there’s more uncertainty, so during the Global Financial Crisis we saw falls greater than 1% every three days, on average. It’s obviously uncomfortable to see your savings buffeted around by the share market, but most people hold a mix of assets also including bonds, cash and property, and the impact on a diversified portfolio will be much less pronounced.

So does volatility mean risk?

Sometimes people in the investments industry use the term ‘risk’ when what they actually mean is volatility. There’s more to ‘risk’ than that though. If you only invest in assets like cash you wouldn’t experience any volatility, but the interest you’d earn probably wouldn’t be much more than inflation. For most people, that would mean there’d be a very high chance that your savings would run out early, or that you would only be able to enjoy a very modest income in retirement.

Assets like shares can be more volatile in the short term, but you get compensated for this by earning a higher return over the long term. If you’re prepared to ride out the day to day volatility, this can help to reduce the long term risk that your savings prove inadequate to meet your retirement goals.

Your financial planner can help you to understand how much risk you need to take, and to structure a portfolio that will help you achieve your goals and the lifestyle you want in retirement.