Time & Risk

Quick changes can speed you forward or take the wind out of your sails.

Volatility is the speed with which an investment gains or loses value and the frequency of those changes. The more volatile an investment is, the more you can potentially make or lose in the short term. For example, equities tend to change price more quickly than most fixed-income investments (bonds and bank deposits). But it's not always that simple. The price of stock in large, well-established companies tends to change more slowly than stock in smaller, or newer, companies. And the more predictable a company's business, the slower the price fluctuation is apt to be. There are other factors to consider, too. Low�rated, high-yield bonds, often known as junk bonds, and some bond funds fluctuate in price at least as often as stocks, and offer some of the same opportunities for gain � and loss. Junk bonds may provide higher income than other bonds in the short term but are more likely to default on their obligations to pay principal and interest, just as some speculative stocks may lose all their value.

Time and Risk

Volatility poses the biggest investment risk in the short term. Sometimes if you wait, and hold onto your equity investments until a market downturn ends and recovery begins, its effect may be reduced. Similarly, if you hold onto your bond investments until maturity, changing market values have no impact on their par value or their interest payments.

Volatility may pose several serious problems, though. If you have been planning to sell an investment to pay for the down payment on a home, college tuition, or any other goal, you may not have enough to cover your costs if its price has fallen dramatically. Or, you may be so concerned over the falling value of your investments that you sell. Not only does that lock in your loss, but you'll no longer own the investment. If its price rebounds, you can't share in its potential recovery. But, of course, your investment may not recover even if the market rebounds.

Historically, major drops in the stock market � including market crashes and bear markets, when the value of stocks drops 20% or more � have been ultimately followed by a period of recovery. If you look at the big picture, you'll discover that what seems to be a huge drop in price often evens out when it is part of a long-term pattern.

Another way to deal with volatility is to capitalize on it. If an equity increases dramatically in value, you can sell it and make another investment. Then, if the price of the equity you sold drops, you can buy it again and wait to see if the cycle will repeat itself. The one investment strategy that's pretty much doomed to failure is trying to time the market, or predict what the stock and bond markets are going to do next so you can be in the right place at the right time. The reason? It can't be done. Or at least nobody has been able to do it successfully over a period of time.

Watching the Movement

If you recognize a certain trend in stock prices, you may be able to turn it to your advantage. For example, some investments, known as cyclicals, move in identifiable patterns, up in certain economic climates and down in others.

If you invest when a cyclical stock is down and sell when it's up, you benefit from the movement. One problem, of course, is knowing when to get in and out.

Other investments are more volatile and less predictable. For example, technology stocks (and the mutual funds that invest in them) jumped dramatically in value during 1995. But in the years before that many of them performed rather poorly.

Reading the Wind

The range between an investment's high and low price over a period of time � often a year � is one measure of its volatility. The smaller the percentage of change the less volatile the investment.

For example, a stock that increases in value from $15 a share to $20 a share over the course of a year has a 33.3% volatility rate, while a stock that increases from $45 to $50 over the same period has a volatility rate of 11.1%. The assumption is that a stock that increases by a large percentage could easily fall by the same percentage, providing a potential loss.

One strategy some investors use to avoid volatility is to sell stock when its price increases or drops a predetermined percent, often in the range of 10% to 20%. One way to handle this approach is to put in a limit order, an instruction to your broker or advisor to sell any investment automatically when it drops to the level that you set.

No Pain, No Gain

Illogical as it may seem, predictability is sometimes a bigger stumbling block to achieving your long�term investment goals than volatility. For example, the rate of return on a bank issued certificate of deposit (CD) is predictable. The problem is that while what you earn on the CD may be higher than the return on a stock, bond, or mutual fund during a market downturn, it doesn't have the potential to increase in value. When the CD matures, you can roll the principal and interest into a new CD at whatever the current rate is. But you can't sell the CD for more than you paid for it, and you can't earn more than the current rate that's being offered. What's more, while what you can earn on a CD increases when interest rates are high, your real rate of return, after taxes, is rarely greater than the rate of inflation.

Volatility's Reward

Don't get the mistaken impression that volatility is to be avoided at all costs. It can work in your favor at least as dramatically as it can work against you. In fact, a strong stock market often produces rapidly increasing prices in a relatively short time. That, in turn, can increase the value of your investment portfolio.

Leveling Out Your Risk

You can neutralize the impact of volatility with a buying strategy known as dollar cost averaging. Using this approach, you invest the same amount regularly in a specific investment, such as a mutual fund, paying whatever the going price is. When the price goes up, your dollars buy fewer shares. When it goes down, they buy more. The effect, over time, can be to lower the cost of the average share of stock or mutual fund you buy, so that you end up with more shares for less money. But remember that while dollar cost averaging has advantages if you invest consistently over time, it doesn't guarantee a profit or protect you from losses in a falling market.