Market Volatility: the Importance of a Diversified Portfolio

Posted on June 7, 2020

It cannot be said too often that the value of investments can go down as well as up. Even cash, which sees its face value remain constant, is subject to the effects of inflation.

Whilst other asset classes can offer a higher rate of return than interest on a savings account, they are also more risky. All investments are subject to stock and other market forces: there are ups, and there are downs.

When it comes to equities, changes in their market value (both individual share prices and collective fund prices), together with the amount and frequency of change, is referred to as volatility.

Whether it takes the form of a ‘dip’ or a ‘downturn’, an ‘upswing’ or a ‘rally’, volatility is an integral part of the stock market.

Volatility is created by a large number of factors, both domestic and international. The UK stock market has been impacted by debt in the Eurozone, US economic stagnation (the ‘credit crunch’ of 2007/8 originated in the US mortgage market), and even economic issues from or concerning China (whether internal reform or external trade war). Volatility is therefore an extremely complex – and asset dependent – concept. The better understanding an investor has of it, the more informed choices they can make.

Attempting to Predict Volatility

Volatility can be measured, with the most common measurement is referred to as ‘standard deviation’. This works as follows: no matter how much it rises or falls, an investment will have an average value over time. The highest and lowest relative values are a deviation from this average amount, so a very volatile investment is said to have a higher standard deviation.

Standard deviation can be used to produce a ‘forecast volatility’ figure as a quick indication of the likelihood of the asset’s value rising or falling.

Using the past to predict the future is far from a perfect system, and no more so than with equities. But one thing is certain: the shorter the investment term, the more risk volatility poses. When you consider that profits or losses on investments only become real when equities are converted to cash, you can see why many investors favour strategies that are lower volatility and longer term. There is less risk, and more time for any kinks and bumps to even out; both of these are conducive to a better night’s sleep.

Correlation

In investment, correlation refers to shared rises or falls in the value of the different assets that make up your portfolio. If your holdings are all subject to very similar or even identical market forces then their values will be highly correlated: that is, they will all be impacted by the same circumstances. A portfolio made up this way would be said to be poorly diversified.

Portfolio Diversification

From share price crashes to negative equity in the housing market, there is no one particular asset class that consistently delivers positive returns. It is impossible to remove risk from investing, but it is possible to mitigate some risk by picking a range of assets that are likely to perform differently under the same market conditions. In other words, the aim of diversification is to increase the likelihood that a fall in the value of some of your assets will be covered by a rise in the value of others.

Do you always want to be diversified?

Some investors prefer to concentrate on a certain type of asset. It must be said that, even with experience, expertise, and an intimate knowledge of every known factor that could impact asset value, it is still possible to get it very wrong and to make huge losses.

Diversification in practice: adjusting the asset mix

Investments can be diversified within an asset class. For example, corporate bonds typically offer higher returns than government bonds, but both bond types carry the risk of unpaid interest or even a failure on the part of the bond issuer to redeem it at term. Find out more about asset classes.

When it comes to equities, newer companies in a sector like IT or digital can see huge growth and rapid share price rises, or they can fail if their offering is not adopted widely enough. Older companies in more stable sectors can return steady, if unremarkable, dividends.

Investments can be made across different countries and continents, and markets in different parts of the world will usually not see similar activity: each has their own local sentiment which will affect both short term and long-term stock performance, even before you factor in local financial and economic factors. International investments also open a can of worms in the form of currency exchange rates, which can change significantly within one day. Find out more about currency fluctuations and international investments.

A financial environment that is considered healthy with economic growth will tend to see more investment in equities and less in bonds, and perhaps holdings in smaller companies and emerging markets. If the economy is struggling, then holdings in larger companies that are less dependent on favourable financial conditions may be wiser. But even diversified equities held across multiple sectors, industries and countries will still be at risk from a systemic risk such an international stock market crash.

Building your own diversified portfolio

Setting aside the required knowledge to make prudent acquisitions in the first place, staying up to date with developments in all markets you are invested in and the performance of the relevant corporate stocks is time-consuming.

This is where professionally managed funds come in. A single fund will usually offer limited diversification (they tend to focus on a few assets, within one class and even one region), but a prudent mix of funds covering a wide selection of assets will spread both risk and reward factors. There are also multi-asset funds that aim to provide ‘off the shelf’ diversification.

Always conduct regular reviews

Even a diverse portfolio needs regular monitoring. Risk profiles for equities and funds are subject to constant change. An investment manager might consider it prudent to adjust the individual assets held, the amount, and the asset class ratios.

As stated at the outset, every single equity and every single asset can be subject to multiple factors: local and geographic; niche, sector and industry; financial and economic; political and social; and even environmental.

For this reason, creating and managing a variety of equities that are not just diversified, but sensibly diversified, is likely to be beyond the means of an individual who is not a professional investor.

INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.

THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED. PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.

No guarantee can be given that the information provided is accurate in the present or the future. It is not intended to constitute either a statement of applicable law or financial advice, and responsibility cannot be accepted for any subsequent loss following activity or inactivity by any individual or organisation. Indeed, such information should NOT be acted upon without first receiving appropriate and specific professional advice.