Market volatility is a statistical measure of the tendency of a market or security to rise or fall sharply within a short period of time. It is typically measured by the standard deviation of the return of an investment. Standard deviation is a statistical concept that denotes the amount of variation or deviation that might be expected.
Volatile markets are usually characterized by wide price fluctuations and heavy trading. They often result from an imbalance of trade orders in one direction, such as all buys and no sells.
Some experts suggest that volatile markets are caused by occurrences, such as economic releases, corporate announcements, recommendations from well-known analysts, a popular initial public offering (IPO,) or unexpected earnings results. Others blame volatility on day traders, short sellers, and institutional investors. With proper retirement planning, you should be able to handle volatile markets when they happen.
One explanation is that investor reactions are caused by psychological forces. This theory flies in the face of the efficient market hypothesis (EMH), which states that market prices are correct and adjust to reflect all information. This behavioral approach says that substantial price changes result from a collective change of mind by the investing public. It’s clear there is no consensus on what causes volatility; however, because volatility exists, investors must develop ways to effectively handle it.
Three Concepts You Should Understand
- Market Dynamics - Market Dynamics are essentially supply, demand, and pricing economic models. When there are continual changes in the supply and demand of a product or a group of products in a given market, the price signals are created. The specific changes in the supply and demand of a product or a group of products force a corresponding change in others due to these variances the pricing signals that are created. Market dynamics describe these dynamic price signals.
- Market Timing - Market timing is the act of moving in and out of the market or switching between asset classes based on using predictive methods, such as technical indicators or economic data. Because it is extremely difficult to predict the future direction of the stock market, investors who try to time the market, especially mutual fund investors, tend to underperform investors who remain invested.
- Behavioral Investing - Behavioral finance combines social and psychological theory with financial theory as a means of understanding how price movements in the securities markets occur independently of any corporate actions. Anyone knowledgeable in the financial market understands that there are numerous variables that affect prices in the securities markets. Investors’ decisions to buy or sell may have a more distinct margin that affects the impact on the market value than favorable earnings or promising products.
How to Handle a Volatile Market
If you are in your 20s and 30s, and you are investing for retirement, then your best option is to not take any drastic action. When you put money into your 401(k) during an economic downturn, you’re actually taking advantage of a lower-cost environment. Therefore, don’t panic. On the contrary, you should invest more.
If you are a young investor, your rate of return typically matters less than your savings rate. What does that mean? If you’re 30 with $20,000 invested, whether you earn a 10 percent or a 5 percent annual return will only result in a difference of around $1,000 in a volatile market. If you can put an extra $5,000 toward retirement, that has a much bigger effect your portfolio value in the long run.
Make sure you have enough cash reserves built up to cover your upcoming expenses, including school tuition and planned vacations. If not, consider raising cash from your portfolio now rather than later after markets have fallen.
During a volatile period in the market, you should have at least two years’ worth of living expenses built up to weather the market. But more can be better if you have the ability to save up more.
Financial Services from Boulay
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