Investor Essentials: Volatility explained

What is market volatility and what causes it?  

Volatility can be defined as a sharp and unpredictable change in the value of investments – both up and down. The value of equities and bonds change throughout the day as parts of the intertwining cogs of the wider financial system.   

Markets can be swayed by political and economic factors, such as speeches and new policy announcements from politicians or central banks; by wider geopolitical factors like war or energy shortages; and by daily updates from listed businesses themselves subsequently informed by the opinion of traders.   

All this makes a difference; one day you may see the value of your portfolio is down, the next day it could have fallen even further, but by the following week it may have grown in value. Accurately predicting day-by-day movements in markets is an impossible task. Instead, smart investors should only really be thinking about the long term, putting money to work for a period of at least three years.   

How can volatility affect me?  

For any investor, the first time they see that their portfolio has lost, rather than gained, money can be a disappointment. In fact, very few investors will have only ever seen a one-way upwards journey. The important point is to understand that volatility is a natural part of the longer-term journey to reach your investment goals.   

It’s understandable that you may want to check the performance of your portfolio on a regular basis, but it’s also likely that on some days you will see losses – and on some days you will see gains.  

However, avoiding the temptation to make changes to your portfolio based on the day-to-day movements is important. If the risk level you have selected and the length of time you wish to invest for is still accurate, then you can allow yourself the comfort to know that you have already made sensible steps towards a longer-term financial goal.   

Can I avoid volatility?   

The simple truth is that if you are investing in equity and bond markets, through discretionary portfolios such as those offered by Nutmeg, then it is impossible to avoid volatility altogether.  

For Nutmeg clients who are feeling uncomfortable with volatility, they may wish to reduce their exposure to risk assets, namely equities – accessed through Exchange Traded Funds (ETFs) – by changing their chosen risk level via the Nutmeg app or website.  

Still, while past performance is no guarantee of future returns, history has shown us that volatility can be your friend should you take a long-term approach to investing. 

How Nutmeg manages risk  

It’s important here to note how Nutmeg manages risk. Take the Fully Managed portfolios as an example: the risk scale of 1 to 10 primarily reflects the split, often called asset allocation, between perceived higher-risk assets (equities) and the bond market that has traditionally (though not always) exhibited less volatility.   

Remember that these asset classes do not always perform to type. For example, 2022 was a particularly bad year for bonds as the world’s major central banks raised interest rates in a bid to control inflation.  

For the lowest risk level 1, most of your money will be invested across developed market government bonds, the money market, or in corporate bonds. The vast majority of any equity exposure will be in developed markets, such as the US, UK, Europe, or Japan.   

Moving all the way to the highest-risk level 10, where the vast majority will be invested in equities, including emerging markets such as China and Brazil. Exposure to bonds will be more limited.   

Note that a higher-risk portfolio does not mean it is invested in unregulated or alternative assets, like private equity or property, or unlisted companies outside of major indices. Nutmeg only ever invests in markets through expert selection of liquid and transparent ETFs. 

Should I sell when markets are volatile?  

Remember a loss is not crystalised as a loss until the investment is sold. If your portfolio is down today, it may not be down in a month’s time.  

When you choose to sell your investments depends on your own personal circumstances. However, if you have set a timescale and risk level that you are comfortable with then you should consider sticking with it, so long as you still have money kept elsewhere in reserve for emergencies.   

Your first year as an investor can be stressful because 12 months in isolation is more likely to show losses than a longer timeframe. It’s understandable that volatility can cause stress, especially if you are not used to seeing negative figures when dealing with your finances.  

However, as the chart below shows, the likelihood of making a loss should go down over time, and so too can those feelings of anxiety. What might seem like a big movement one day may be just a blip when viewed over several years, though historical performance does not guarantee future returns.   

Chart: Historical probability of loss decreases by holding equity longer (1972 – 2023)  

Source: Macrobond; MSCI World Equity Mid and MSCI Large Cap Total Return in GBP, 1 March 1972- 13 March 2023 

A fresh perspective  

Once you get to grips with volatility as a natural part of investing, with the understanding that the longer you invest, the less likely you are to lose money, this can help to ease some of the anxiety you may have about investing.  

No investment is ever guaranteed to deliver returns, but a measured approach over a sensible time horizon can help to maximise your chances of reaching your financial goals.   

If you do feel you would like to discuss your financial goals further, you can also book a free call with one of our experts.  

If you’ve found this blog interesting, we have plenty of other articles in the Investor Essentials series available on compounding, diversification, and tax wrappers.   

Risk warning   

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.