When you turn on the radio or television or log onto Twitter or Facebook, you might assume volatility is a terrible thing requiring all investors to panic and make changes to their portfolio immediately. When movement in the stock market is up one day, noticeably down for the next week, then appears to be traveling upward again, only to spiral downward again, that's what traders and investors call stock market volatility.
But it's important to understand that this movement is not all bad for investors. Everyone talks about volatility as a detriment to markets and investors, but no one talks about the opportunities that arise for investors during periods of market volatility.
Market volatility is the statistical measure of a market or security's tendency to rise or fall sharply within a short period of time. Measured by standard deviation, volatility can be caused by the imbalances within trade orders in one direction or another. Volatile markets are characterized by wide price fluctuations and/or heavy trading.
Although there are inherent negative aspects, believing all indicators of volatility are negative is dangerous. Volatility can drive the novice investor to question his or her own investment strategies strictly due to short-term fear. It is crucial for investors to understand that volatility is inevitable, and attempting to navigate around it is risky.
Markets tend to move up and down in the short term, and volatility should not be the deciding factor as to whether or not investors should immediately exit. With a strong understanding of volatility and its causes, investors potentially can take advantage of investment opportunities resulting from volatile markets. Here are two strategies to help you leverage volatility for your own benefit.
1. Ignore short-term chaos and leave investments until the volatility passes. One effective method commonly used in times of market volatility is to stay the course despite the current overreaction of the market. Even though this may seem lazy and counterproductive, it may insulate you from losses associated with attempting to time the market.
It is virtually impossible to time the top to determine when to get out, and just as difficult to discern the bottom and when to get back in and invest again. Typically, you would be better off to stay the course than attempt to time things and not do it well. This bad timing can further exacerbate your losses during these volatile times.
2. Purchase additional shares at lower prices. Market volatility can also create opportunities an astute investor can use to their advantage. Volatility can provide entry points for those investors whose time horizon and investment strategy is long-term. Downward market volatility presents investors who are bullish and believe markets will perform well in the long run with the opportunity to purchase additional shares at lower prices.
Increasing your position at a discount can be a very powerful strategy. In effect, you are lowering your average cost per share of that particular security. This volatility provides an excellent environment for those with long-term time horizons, especially millennials and later generations, with an opportunity to increase their returns over time by making additional investments. This may sound and feel counterproductive at the time, but could add significantly to the investor's performance.
Periods of market volatility are a great time to invest funds you may have on the sidelines and liquidate and redeploy underperforming assets to put your money to work while the opportunity presents itself. This thinking must be also in line with your risk tolerance and overall objectives.
Have a plan in place outlining your goals, objectives and time horizon before you need it, and review it regularly to ensure it serves you well during all types of markets. This will help you navigate through periods of uncertainty when many people are panicking or acting out of fear. Volatility is not all bad, as long as you are prepared to take advantage of the unique opportunities it brings.
(Editor's Note: This article originally appeared at Investopedia.com.)
— By Lawrence Sprung, president of Mitlin Financial