Understanding Volatility and Five Ways To manage It.

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We need to talk. Specifically we need to talk about this things called volatility.

It’s something that people get so afraid of encountering along their investing journey.

It makes me think of the troll living under the bridge in the story of Billy Goat Gruff, singing his song – “I’m a troll, fo-di-roll, and I’ll eat you for my supper” and preventing the goats getting to the juicy grass on the other side.

The truth is, volatility is not scary at all, it’s not dangerous and it most certainly won’t eat you for it’s supper, but if you don’t understand it and believe it is scary, your fear and ignorance could be the things that keeps you away from your juicy fields of grass.

Understanding volatility, knowing what it is and how can you manage it and deal with it is what this video is all about. Watch it now.

Volatility is about ups and downs. Think of it like the markets mood swings.

Simply put volatility is the rate of change of the price in an asset.

When we talk about volatility, most people immediately think about the stock market or equity investing. This is because equity investing is one of the most liquid ways you can invest and the price feedback from the market happens almost instantaneously thanks to the internet, so it can feel like there are these wild price swings.

You also have volatility in the property market. You have volatility in businesses. You have volatility in every market As soon as there is something to sell and something to buy, there will be price variations.

With property, businesses and other asset classes, it’s way more difficult to get a moment by moment valuation, so people don’t tend to think of volatility or the ups and downs of prices, when they think about those asset classes.

Volatility is also sometimes referred to as investment risk. The bigger the potential rate of change of the price and the range of the price change, the greater the volatility, the bigger the “risk”.

So with all assets, the price goes up, the price goes down, the price goes up, the price goes down. How fast the price changes and the expanse of that rate of change is known, as your volatility index.

There is one BIG volatility index which measures how the overall markets volatility is changing. i.e are prices moving faster and in bigger ranges across the whole market or are they moving slower and in a smaller range.

This BIG MAMMA Volatility index is called the VIX.

It’s full name is the Chicago Board Options Exchange Volatility Index. It is a measure of the stock market’s expectation of volatility implied by S&P 500 index options.

Cutting through the jargon (yep, another one for the Jargon Buster).

This index is put out by the Chicago Board Options Exchange to give us a sense of how “up & down” the market is getting and whether the overall direction is trending down or up.

Historic volatility also tells us some stories that may be useful predictors of the future. For example, in the past, when we’ve entered a bear market, so a bear market which is when the market is trending down, and it’s gone straight down – the volatility tends to be small, because it’s a one way direction – down. In a strong bull market, this is when the prices are going up on the stock exchange, again, your volatility index can be small because it’s also a one way direction.

A high VIX or volatility happens when the market can’t make up its mind whether it wants to be a bull or a bear – so it goes up and down and a lot of sideways.  

A high VIX can indicate a transition between a bull and a bear market, or sometimes we can have long periods of sideways movement. Bigger volatility also comes about when there are periods of uncertainty.

Maybe there’s political uncertainty.

Maybe there’s social economic uncertainty.

And boy, we certainly have a lot of that right now, and it’s reflecting in the VIX getting bigger and it’s making people jitterish.

What happened when volatility increases?

People who don’t understand it, end up sitting on the sideline which is where you NEVER want to be.

Remember,

Time and time again I get people saying to me – “ Ann, prices are really high right now, or prices are dropping now, I’m afraid of investing now, I’ll just sit on the sideline and wait.

That’s the worse thing we can do. Not being in a market is super dangerous, because then we don’t have assets working for us.

And I get it, it can be a bit frightening when we look at the prices going up and down.

How do we deal with volatility?

The very first thing you need to do is, DON’T PANIC.

Understand that volatility is absolutely normal.

Price of markets around the world go up and down for two primary reasons.

REASON #1 – Fundamentals. The price can go up and down because of fundamental changes in an underlying stock or sector. Maybe a certain market has shifted, something’s happened to a specific market sector that can make the actual asset become less valuable or more valuable.

REASON #2 – Emotions. The far greater impact on volatility is emotions.

Yes, us humans love to think we are logical being, but in fact we are driven by our emotions.

Things happen out there, the news gets all hyped up and the market reacts. It’s got very low EQ!

So there you have it – volatility is completely normal.

In any trend, be it a bull trend, be it a bear trend, there’s still volatility.

The are micro movements happening all the time – second by second, minute by minute, day by day, week by week – but over a longer period of time, it all dampens out.

It’s all about perspective and remembering we are here for long term sustainable wealth. We are here to own quality assets and have them working for us. We don’t give a damn about the minute by minute change.

If you feel yourself getting caught up in the emotional swirl, here’s what you do.

  1. Remind yourself you’re interested is the longer term trajectory not the moment by moment movement, so you don’t panic and instead you get on with your life, remembering volatility is completely normal.
  2. Assess the truth of the situation and remind yourself WHY you are investing. Have a good intimate conversation with yourself…“I’m creating my financial wellbeing, I understand I need assets working for me. The stock market, investment property, low input businesses, these all the assets I need working for me. Okay, so nothing has changed regarding why I’m doing what I’m doing. What is my strategy that I’m following? Am I investing in low cost index trackers? Am I managing the things that I can manage? Yes, I am. Great, can I manage the emotions of the market? No, I can’t, so let me come back to what is in my control – my emotions.”

Most of the strategies I teach are about about consistent regular investing and these strategies will not change with short term adjustments in the market.

  1. The third thing we do to benefit from volatility is we buy quality. When we are buying quality, we don’t really care about what’s happening with the micro movements. The easiest way to buy quality is to own the best of the stock market via Index Trackers

So why is buying the index the quality move and the best way to manage volatility?

Here’s an example. Say your core home market index tracker in your portfolio is the FTSE 100. So that means with this particular regular investment you are buying shares in the top 100 companies listed on the London Stock exchange with just one Index Tracker purchase. If a sector of the market shifts fundamentally – say we’ve gone from horse carts to cars and now there’s no longer business for horse carts – all of your horse cart companies listed on the exchange and within your Index Tracker fund are going to lose value and drop out of that particular Index and now your car companies that are replacing them are going to come into that index.

You don’t have to go chasing after and finding those new rising companies because the natural market changes will mean that the companies that are no longer performing are going to drop away and the other companies that are growing, that have sustainable businesses are going to come into that index.

So the very fact that you buy the Index in a design portfolio means you’re always buying the top companies and there’s natural falling out of the ones that are no longer performing and you don’t have to worry about that.

  1. The fourth thing to do to manage volatility is to spread the risk. Meaning you spread the volatility. Remember we spoke about this word risk being so misunderstood. Risk just means volatility. The rate of change in the share price. In any moment the value of your investment can go up and down. So you spread the volatility (and thereby minimise with within your overall portfolio) by using two core investing principles. The first principle is diversification and the second principle is asset allocation.

Diversification means you don’t want just one egg and you don’t want all your eggs to be from the same batch.

Let’s say you’ve got a basket of duck eggs. You want more than one duck egg.

So let’s say duck eggs are your equities, these are shares in businesses. You want to make sure you have shares in a whole lot of businesses, the worst thing you want to do is have just one or two or three or even 10 shares in only 10 companies. That would be risky. What you want to is a basket of a whole lot of shares, and that’s why index tracking investing is so cool.

By investing in a single index tracker, let’s say an S&P 500 index tracker fund, with a single investment you’ve automatically get diversification, because with that one investment you own shares in the top 500 companies listed in the US.

That’s diversification within one asset class.

You want diversification in every asset classes. Say you have a collection of investment property. Let’s call that your chicken eggs.

Once again you want diversification within this asset class – you never just want one investment or all your property to be exactly the same and in the same location. That’s real risky business.

If you’re going to invest directly in property, it’s way better to have a whole lot of smaller units, instead of just having one big property. You can also get diversification across your property asset class by investing in real estate investment trusts or better yet, an index tracker that tracks a whole bundle of real estate investment trusts so that you get investment property in retail, in commercial, in industrial and in different regions and countries.

This is how you manage volatility. If something happens in one sector, or one market or one geographic region, it doesn’t matter, because you’ve got exposure in others. Diversification dampens down the big up’s and down’s.

The second investment principle to use to manage volatility is asset allocation.

Having different type of eggs is asset allocation. You want to be investing in equities, investment property, low input businesses, loan instruments, commodities, gold, crypto’s etc – because every asset class goes through different cycles and has different ranges of volatility.

When you are invested in different asset types (called asset classes), these different volatility cycles dampen each other and you get this nice stability and constant growth in your asset portfolio.

The fifth way to deal with volatility is by regular investing. This is my favorite way and something so many people get wrong. You need to make a habit of regularly investing into assets. The easiest asset class to do this in is your stock market investments, in these things called index trackers.

When you set aside a fixed amount of money and every month money buy you you units in your chosen index trackers, it means that when the price goes up, you get fewer units for your money. Better still, when the price goes down, you celebrate, because now your quality assets are on sale.

For the same amount of money, you get more units in that specific index tracker fund. Whether it’s in a unit trust type or whether it’s in an ETF, it doesn’t matter, you get more for your money.

Over time, the average number of units that you buy for that fixed investment balances out and you actually get a lower average cost per unit.

This is another reason why regular investing is so sexy because it balances out volatility.

In the comments below, I’d love to know:

  • What have you learnt about volatility and which of these five things can you apply in your life right now, to deal with the anxiety generated by volatility?

Remember, assets and money are here to serve you – not enslave you. They are meant to support you in living your greatest, juiciest life – so learn about them and learn how to give your money and assets great leadership – so they can do what they are meant to do.

Big love

Ann

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