The market goes up, the market goes down. Stocks tumble, stocks recover. Bonds fall, bonds rise.
Though the ups and downs of investing are often compared to a rollercoaster ride, we prefer to think of it as a long drive — and we encourage investors to do the same.
When you take a long-term perspective, the hill (or valley) you happen to be passing through at the moment is simply another part of the trip, terrain you must pass through on your way toward your long-term destination. More importantly,
long-term returns for the bond and equity markets have historically always been positive. So, with this longer term perspective, it's easier to deal with market volatility and risk as simply par for the course... and easier not to react emotionally to every up and down.
Here's how to incorporate volatility and risk into your investment planning.
Risk, Volatility and Your Comprehensive
First, some definitions. While the terms "risk" and "volatility" are often used interchangeably, they're actually not the same thing. Volatility is the measure of value or returns for a given security, like a stock, or an index. Volatility can also encompass other concepts, such as the amount a security or index is up or down, the time period in which that volatility takes place, and whether or not short-term volatility evens out over time.
In contrast, risk is most easily defined in terms of its relationship to reward; in general, the more risky an investment, the more potential exists for reward. For investment professionals, risk is measured in terms of how risky (or not) a particular investment is as compared to other investments. For individual investors, risk is more often defined in personal terms, such as, can I stand to lose this much? What would happen to my financial future if I invested in a company that failed or bonds that defaulted?
Both volatility and risk can act as emotional catalysts for investors, but there's a key difference: Investors have no control over volatility, but they do have control over how much risk they take on. That's why your trusted family wealth advisor will recommend that you develop a diversified portfolio that spreads risk over a number of asset categories.
Risk and Diversification: Key Financial Planning Tools
There are two main types of risk: Systemic and unsystemic. Systemic risk is tied to uncontrollable factors, such as interest rates, natural disasters, the economy as a whole, and the like. It's measured by comparing a security to an index (which is a broad collection of assets of the same type). In contrast, unsystemic risk is measured by comparing a particular security's performance to that of its peers — thus, you can diversify away some of the associated risk through asset allocation.
Your wealth advisor may suggest balancing risk by creating a portfolio containing assets that move in different directions. For instance, stocks tend to move up and down with the market, paired with bonds, that don't move as much, but generally produce lower income. At Premier, we recommend diversifying even further by careful allocation within asset classes as well, with a range of stocks from large to small companies, value and growth stocks, international, and even emerging market stock.
It's easy to get risk and volatility tangled up, especially when daily headlines are screaming out market ups and downs. But remember, a full market cycle takes about a decade, so it's important to look at the long-term picture, rather than the day-to-day peaks and valleys. Work with your wealth advisor and make investment decisions based on your long-term goals, rather than short-term volatility. Daily fluctuations will lose the power to toy with your emotions when you learn to look at risk through a broader, temporal perspective.