Market volatility is a complex subject, but, in simplest terms stock market volatility measures fluctuations in stock prices. Low volatility means small fluctuations and high volatility means large fluctuations.
When markets endure downside volatility, investors need not look far to be able to point toward a reason. Whatever the reason at the time, it's important to understand how to deal with it. While each investor's situation differs, there are two key factors for weathering market volatility…
Diversification and Your Risk Budget
You've heard about diversification, you know it makes sense, yet, when it comes to knowing how best to diversify investments, you're just not sure you know how to do it. We think that one of the reasons it's hard for individuals to properly diversify is the lack of a true understanding of your own risk budget.
Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. One of the major goals of diversification is the lack of correlation of one investment to another. When one is moving down, another may be moving up. When you diversify your investments, consider the level of risk of a particular sector or asset class. For example; financials, technology, and consumer staples are sectors of the market with potentially different levels of risk. An asset class could be, for instance, a stock, bond or money market instrument, all of which have potentially different levels of risk as well. The higher your risk budget, the more you may diversify in that riskier investment, the lower your risk budget, the less you may diversify into that riskier investment.
What Are Some of the Factors of Your Risk Budget?
- Time Horizon – how long until you need to use the money?
- Liquidity – if this pool of money is for the long-term, do you have other resources in case of an emergency? Or, would you need to use some of the money in an emergency?
- Comfort Level with risk – how much or little does loss on your money affect you personally, emotionally? Does it become a focus of your attention and keep you up at night? Or, do you have little to no concern?
According to Morningstar, risk budgeting is the process of identifying, quantifying, and spending "risk" in the most efficient manner possible. If you have the answers to the factors of your personal risk budget, you'll be well on your way to determining if you are diversifying your money in a manner best suited for you.
Now is a good time to take a look at your investments and better understand how your risk budget aligns with the diversification of your investments. If you don't want to go it alone, make sure to contact your financial advisor.
Important Note: Please note that nothing in this post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and should not be taken to be, investment, accounting, tax or legal advice. If you would like investment, accounting, tax or legal advice, you should consult with your own financial advisors, accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Lenity Financial, Inc. unless a client service agreement is in place.
Sources:
Forbes.com -Markets 101: Volatility Explained
Morningstar, Inc., Harvard Business School Online – Brian Misamore, Staff – 9/21/17
Lenity Financial, Inc. – Risk Budget