Volatility: What It Is and Why It Matters in Investing

Volatility describes how much and how quickly the price or value of an investment changes over time. Investments with larger or more frequent price movements are generally described as being more volatile.

What Is Volatility?

Investment prices do not always move in a straight line. A share, fund, index or other investment may rise or fall over different periods. Volatility is a way of describing the degree of these fluctuations.

Why Do Investment Prices Change?

Investment prices can change for many reasons. Buyers and sellers continuously react to new information, expectations and changing market conditions.

Factors that may contribute to price movements include:

• Company earnings and financial performance.
• Economic conditions and interest rates.
• Inflation and changes in purchasing power.
• Political or geopolitical developments.
• Investor expectations and market sentiment.
• Changes in industry or sector conditions.
• Unexpected events and new information.

Volatility Does Not Automatically Mean Loss

Volatility refers to price movement in both directions. An investment may experience sharp increases as well as sharp declines.

However, higher volatility can increase uncertainty because the future value of an investment may be more difficult to predict over shorter periods.

Volatility and Investment Risk

Volatility is one way investors may think about investment risk, but it is not the only type of risk. Investments can also involve risks such as credit risk, liquidity risk, inflation risk and the possibility of permanent loss of capital.

An investor should therefore avoid assuming that volatility alone provides a complete picture of an investment's overall risk.

How Can Time Horizon Affect Volatility?

Short-term price movements can be significant, particularly for investments that are exposed to market conditions. Investors with different time horizons may experience the effects of volatility differently.

A longer investment horizon may provide more time for an investor to remain invested through periods of market fluctuation, but it does not guarantee recovery or positive returns.

Volatility and Investor Behaviour

Large price movements can sometimes lead investors to make emotional decisions. Fear during falling markets or excitement during rapidly rising markets may influence buying or selling decisions.

Understanding that price fluctuations can occur may help investors evaluate whether an investment approach is consistent with their financial goals and ability to tolerate losses.

Can Diversification Help?

Diversification involves spreading investments across different securities, sectors, asset classes or other categories. Depending on how investments behave relative to one another, diversification may help reduce excessive exposure to a single source of risk.

However, diversification cannot eliminate all investment losses and does not guarantee profits.

Important Factors to Consider

• How much loss you may be able to tolerate financially.
• How you may react to significant price movements.
• Your investment time horizon.
• Your financial goals and need for liquidity.
• The role of an investment within your overall portfolio.
• Other risks beyond short-term price fluctuations.

Key Takeaways

• Volatility describes changes in investment prices or values over time.
• Higher volatility generally involves larger or more frequent price movements.
• Volatility can involve both upward and downward price changes.
• Volatility is related to risk but does not describe every type of investment risk.
• Time horizon and investor behaviour can influence how volatility affects investment decisions.
• Diversification may help manage some risks but cannot eliminate all losses.