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Canada’s rate cut signals more volatility ahead

Bank of Canada
Patrick Doyle | Bloomberg | Getty Images

It was the rate announcement heard around the country. Well, the country to our north, at least. On Jan. 21, the Bank of Canada made a surprise announcement that it was slashing its overnight rate from 1 percent to .75 percent.

With plummeting oil prices taking a toll on this commodity-rich nation, the BoC decided to cut rates to spur borrowing and help keep the country's economy afloat.

Within two hours of the announcement, the S&P/TSX Composite Index had climbed by 2.5 percent, while the Canadian dollar dropped to below $81 cents U.S., its lowest level in nearly six years.

While the rate cut may not be making big news in America, it does speak to an issue that is certainly impacting investors below the 49th parallel: increasing market and economic volatility.

Read MoreBank of Canada in shock: rate cut amid oil slump

For the last couple of years, investors have had a fairly smooth ride. Markets have steadily climbed, and there have been minimal ups and downs.

Since Dec. 5, though, the VIX—an index that tracks volatility on the S&P 500—has climbed by 55 percent.

That's a dramatic reversal from what investors saw most of last year. Between January and December, the VIX was down by 5 percent.

It's because of decisions like we saw in Canada that we're seeing increasing volatility, said Mark Zandi, Moody's Analytics' chief economist. The main cause of the more frequent ups is diverging Central Bank policy.

While Canada is cutting its rate, in America the expectation is that rates will rise. In Europe and Japan it's all about quantitative easing. There's pressure on the Bank of England—which also made an announcement on Jan. 21 that it was keeping its rates steady—to increase its overnight rate.

"Global banks are moving in very different directions," he said.

Divergence is a volatility driver for a number of reasons, he explained, but a big one is that interest-rate differentials tend to create big moves in currency values.

If the gap between the U.S. dollar and other currencies grow, oil's price could fall further, as it is priced in greenbacks, said Zandi.

But while divergence may be the biggest reason for volatility, it's not the only one.

Read More4 ways to ride the volatility storm

Continued problems in Europe, Japan's lack of economic progress and a slowing Chinese economy are also contributing to more instability.

As well, investors, who have had a great run in equities over the last few years, are becoming more worried about a market correction, he said.

More turmoil ahead

If the Bank of Canada announcement proved one thing, it's that it's unlikely this volatility will die down anytime soon. In fact, it could increase, said Sam Stovall, a U.S. equity strategist at S&P Capital IQ.

Stovall measures volatility by the number of times the S&P 500 moves up or down by at least 1 percent. In 2013 and 2014 the market either climbed or dropped by 1 percent or more 38 times. That's below the historical average of 54 times a year and a far cry from the 84 ups and downs the market has experienced, on average, since 2000.

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In the last month, though, the S&P 500 has moved by at least 1 percent four times. By his calculations, if things continue as they have been, we'll have 72 of these movements. That's still below the average since 2000, but it would be above the average since 1960.

Another reason why volatility is increasing is that our bull run is lasting longer than usual. The average length of a bull run is four a half years; we're about to enter year seven.

Stovall looked at every bull market since 1949 and found that first year of a bull run had the highest amount of volatility. It goes down in year two and three and starts to climb again in years four, five and six. The longer the bull run goes, the more volatile the market gets, he said.

"The further we go, the more investors anticipate an end to the bull," he said. "Investors are like hyperactive first-graders playing musical chairs. They try to out-anticipate the other, and we're now getting increasingly anxious about preparing for the music to finally stop."

Stay the course

Most investors don't like a shaky market, but unfortunately, there's not much they can do. We've been spoiled by low volatility, said Zandi. Now things are simply reverting to the mean.

"We're moving to a more typical environment," said Zandi. "So people need to get over it. This is the real world. It's not a straight line."

People do need to ensure that they're diversified, he said. Volatility tends to be concentrated in certain markets and in certain securities, so if someone's too exposed to one area, they "could get creamed," he said.

Read More4 ways to protect yourself from foreign-currency risk

A short-term rise in volatility won't affect the investor who has socked away his or her money for 30 years, said Stuart Ritter, a senior financial planner with T. Rowe Price, but it could hurt someone who needs money soon. That's why he suggests not keeping funds in the stock market that will be needed within two years.

Investors should be rebalancing during dips and climbs—it's important to keep the original stock and bond asset-allocation mix intact, said Ritter—and they must stick to the plan that they had been following in the first place.

The worst thing someone can do is sell their positions and think they'll get back in when the volatility dies down, said Stovall.

Not only will the market movements likely not subside, there is plenty of research to show that people who sell out tend to buy back in after the market has already rebounded.

People can buy on the dips, when the market is cheaper, but ultimately they should just stay put, said Stovall.

"It's like flying," he said. "When things get turbulent, the pilot says to return to your seat and fasten your seat belt. Not once has a pilot said to don the parachutes and assemble by the door."