To the uninitiated or particularly conservative, term ‘market volatility’ can be a cause of concern. However, speak to any seasoned investor or trader and they will be the first to tell you that volatility is nothing to fear.
In fact, you could argue that market volatility is what makes the financial markets an attractive investment option for so many. Asset prices can be radically shaped by an economic downtown or a major political announcement, increasing both the risk and the potential returns on offer.
2020 looks like it will be a particularly eventful year. If we are just to consider the events in our immediate periphery – the UK’s withdrawal from the EU commencing on the 31 January and the US-China trade war – the calendar is already full of occurrences that could trigger significant shifts in financial markets.
The key message for those worried is simple – don’t panic. While it is not always easy to predict just how the market will react to political and economic triggers, merely acknowledging that volatility plays a natural role in determining the price of different assets is an important step to take.
So, what measures can be taken to ensure that traders’ investment strategy and financial portfolio is effectively placed to manage sudden price shifts?
Don’t put all your eggs in one basket
Diversification is a tool many profess to understand, but an approach that many novice investors and trades often get wrong.
In short, diversification means spreading your investment (and subsequent risks) across multiple markets and assets. Doing so minimises the chances of substantial losses should one of the assets you hold suffer a sudden price drop.
However, diversification is only useful to a certain point. According to research, optimum diversification can be achieved once a trade or investor owns 20 stocks. The benefits of further diversification and risk reduction are set to be minimal when looking beyond this figure. It can also mean that investors and traders spend more time than is necessary managing their various investments with a relative minimal gain.
Finally, an effective diversification strategy needs to be informed by knowledge of the market. Taking the scattergun approach of randomly choosing different assets and hoping for the best will rarely play in your favour. Consult with educational resources and financial advisers before deciding a diversification strategy that is relevant to your long-term financial goals.
Know what type of investor you are
When it comes to making investment decisions, it is important to always keep in mind the following rule – low-risk investments will generally deliver modest returns and are favourable for those relying on an investment strategy spanning 10 years or longer. Alternatively, high-risk investments have the potential to deliver substantial returns in the short-term, though there is a catch – your capital can, as the name suggests, incur significant losses.
Understanding which scenario appeals to you will determine what type of investor you are. Day traders and those highly engaged with the financial markets will typically find themselves towards the high-risk, high-return end of the spectrum, while the opposite can be said of those interested in building a long-term, maturing investment portfolio.
When confronted with a market shock or volatile trading conditions, it is common for high-risk, high-return investors to immediately begin reorganising their financial portfolios. Given their acute awareness of the market, such investors have considered these trades as part of their investment strategy, accommodating for the high risk involved in such trades.
On the other hand, low-risk, low-return investors are more likely to sit back and let the market correct itself in the long-term. Asset prices will generally recover over time, which means any hasty investment decisions not originally accounted for could incur significant losses.
Of course, such investor categories are not clear cut, but having some idea of where you fall on the spectrum can help inform your actions when dealing volatile market conditions.
Understand the principle of cause and effect
Finally, while nothing is certain in the world of trading, it is important to have a basic understanding of how different asset classes react when faced with a particular set of circumstances.
For example, in times of volatility, investors are more likely to rally to hard assets i.e. tangible objects such as precious metals and oil. This is because these commodities have a strong track record of holding their price when the market faces a political or economic shock.
Let’s see this theory in action. Early in the year, investors rallied to gold in response to the escalating military tensions between the US and Iran. The desirability of this so-called ‘safe haven asset’ resulted in the price of gold surpassing $1,600 USD an ounce on 7 January 2020 – its highest price in nearly seven years.
A similar observation can be made about the stock market. In periods of stability, investors look to soft assets like stocks and shares due to the higher returns they could offer. For example, the FTSE100 increased in value by over £30bn in the immediate aftermath of the 2019 UK General Election which resulted in the Conservative Party winning the biggest majority in the House of Commons since the 1980s.
There is no return without risk
One thing we can say with far greater certainty is that 2020 will not be short of twists, turns and new opportunities. Regardless, investors and trades must remember there is no return without risk. Understanding this principle, along with the above pointers, can help ensure your investment strategy is adequately placed to tackle the coming 12 months with confidence.
Further reading: Protecting against downside risk