Volatility is often a cause of concern for investors , but what it actually is, and what it is perceived to be can be two different things.
"In specific technical terms volatility is a statistical measure of the dispersion of returns for a given security, stock or market index," says Lee Robertson, chief executive officer of wealth manager Investment Quorum. "In easier parlance, the higher the volatility of a stock or index, the riskier the stock or index."
And volatility, defined as the degree of fluctuation of share prices, can have positive as well as negative outcomes. For example, higher volatility can lead to share prices increasing, and even if prices fall dramatically this can create buying opportunities.
"Volatility is the price you have to pay for the potentially greater returns of investing in equities," says Martin Bamford, managing director of independent financial adviser Informed Choice.
But what many investors understand volatility to mean is how much money they could lose and how quickly. "For these investors, volatility isn't a statistical formula, but rather the likelihood and extent of any possible capital losses they could suffer," says Patrick Connolly, certified financial planner at Chase de Vere.
Investors tend to worry about this interpretation of volatility when markets are choppy and they fear falls could wipe out investment returns.
Investors who find it difficult to take on high levels of investment risk are more likely to fret about increased volatility, and this can cause problems. "A cautious investor, when faced with high levels of volatility, may suffer from sleepless nights and possibly be panicked into making the wrong decisions such as selling out of an investment after it has fallen heavily in value," says Mr Connolly.
Higher volatility can also be a problem for investors who need to access their money in the short term - within the next five years. For example, people approaching retirement who plan to start drawing an income from their investments soon or those investing to build up a deposit to purchase a property. A fall in markets means shorter term investors might have to cash in their investments when losses have been made, rather than wait for them to recover.
"The larger the loss, the more time it takes to claw back," says Dimitar Boyadzhiev, passive strategies research analyst at Morningstar. "For example, if you have a portfolio worth £10,000 and it drops to £5,000, you will need a 100 per cent gain to go back up to £10,000. But if you only lost 20 per of your £10,000, you'd have £8,000 and would only need a 25 per cent gain for it to recover to £10,000."
However, volatility can be very beneficial if you have an investment timescale of at least five years and can tolerate higher investment risk. For example, if you invest set amounts of money on a regular basis, such as once a month, market fluctuations allow you to benefit from pound-cost averaging. When markets go up and are more expensive your set amount of money will buy fewer units or shares, and when markets fall and are cheaper your set amount will buy more.
How to protect your portfolio from negative volatility
As negative volatility tends to be more of a concern over the short term, if you can extend your investment time frame it means you are more likely to ride out inevitable market bumps. If you cannot commit to investing for at least five years it is generally better to opt for cash, even with low interest rates. Inflation erosion over the short-term is likely to be less damaging to your wealth than a steep fall in equity markets.
Make sure your portfolio is invested across different asset classes including equities, fixed income, property and cash, as diversification reduces risk and volatility. This is because the overall portfolio's return does not rely on the fortunes of just one area.
Investors are often inadequately diversified and have a bias to their home market, points out David Jane, manager of the multi-asset fund range at Miton. But investing across a range of asset classes, regions and sectors reduces the correlation between your positions and means they can potentially achieve different things in your portfolio. He suggests trying to position it to be able to deal with a number of potential scenarios. He explains: "So, for example, if interest rates go up some positions will do well, and if they go down other positions will do well. And if economic growth slows certain positions may do well and if it grows strongly, others might do even better. The right diversification means that whatever happens, your overall portfolio will do alright."
However, constructing a portfolio to lessen volatility is becoming more difficult.
"Market cycles seem to have become much shorter," says Mr Robertson. "Traditionally you'd use bonds to counter volatility but now that's more difficult as quantitative easing has somewhat interfered with this unless you're looking at short duration, but that's expensive. Cash is a decent mitigator of volatility but you're locking yourself into very low rates."
He suggest investors stay away from sector specific funds in favour of more diversified funds, learn to read the beta of a stock - how much it fluctuates compared with a market, and look for low beta constituents. Avoiding areas which have the tendency to be more volatile such as technology and energy is also something to consider.
And even though share price fluctuation is quite low at the moment it doesn't mean the market is not at risk of a sharp fall.
Mr Jane adds: "If what you're afraid of is volatility and risk returning then don't buy the stuff that everybody else is buying, for example, the FAANGS [Facebook (US:FB), Amazon (US:AMZN), Apple (US:AAPL), Netflix (US:NFLX) and Google, known as Alphabet (US:GOOGL)]."
Creating the right asset allocation
What the right asset allocation is for you depends on your individual circumstances, goals and attitude to risk.
For a cautious investor wanting to mitigate volatility Informed Choice suggests a portfolio allocated to cash (10 per cent), bonds (50 per cent), equities (30 per cent) and property (10 per cent).
"It would be sensible to create additional diversification within each asset class," says Mr Bamford. For example, the bond segment would include UK Gilts, Index Linked Gilts, corporate bonds, high yield bonds and global bonds. Similarly, within the equities segment, we would recommend exposure to the UK, US, Europe, Japan and Asia."
Martin Bamford's suggested asset allocation for a cautious adventurous investor
| Asset Class | Fund | Portion |
| UK Cash | Cash | 10% |
| UK Corporate Bonds | Royal London Sterling Credit Class M Inc | 19% |
| UK Corporate Bonds | Baillie Gifford High Yield Bond B Acc | 4% |
| UK Index Linked Bonds | Legal & General All Stocks Index Linked Gilt Index Trust Acc | 7% |
| International Bonds | Marlborough Global Bond Class P Acc | 9% |
| UK Gilts | iShares UK Gilts All Stocks Tracker Fund Class H Acc | 14% |
| Global High Yield Bonds | AXA Global High Income Z Acc | 5% |
| UK Equity | Fidelity UK Index Fund P Acc | 8% |
| UK Equity | Rathbone Income Fund Class I Acc | 6% |
| Europe ex UK Equity | Jupiter European I Inc | 2% |
| North American Equity | Fidelity US Index P Acc | 6% |
| Japanese Equity | Baillie Gifford Japanese Class B Acc | 2% |
| UK Property | Legal & General UK Property Feeder I Acc | 8% |
Source: Informed Choice
Patrick Connolly's suggested allocation for a cautious investor
| Asset class | Portion |
| Equities | 35% |
| UK Equities | 15% |
| US Equities | 6% |
| European equities | 6% |
| Asian equities | 3% |
| Japanese equities | 2% |
| Emerging Market equities | 3% |
| Fixed interest | 50% |
| Strategic Bond funds | 50% |
| Property | 15% |
| Property funds | 15% |
Source: Chase de Vere
For a more adventurous investor with a longer time horizon, Mr Bamford thinks portfolios should be biased to equities and would typically suggest 35 per cent in UK equities and 50 per cent in international equities, alongside 10 per cent in bonds and 5 per cent in property.
Martin Bamford's suggested asset allocation for an adventurous investor
| Asset Class | Fund | Portion |
| UK Corporate Bonds | Royal London Sterling Credit Class M Inc | 2% |
| UK Corporate Bonds | Baillie Gifford High Yield Bond B Acc | 3% |
| Global High Yield Bonds | AXA Global High Income Z Acc | 5% |
| UK Equity | HSBC FTSE All Share Index C | 24% |
| UK Equity | Rathbone Income Fund Class I Acc | 11% |
| Europe ex UK Equity | Jupiter European I Inc | 5% |
| North American Equity | HSBC American Index C | 7% |
| Japanese Equity | Baillie Gifford Japanese Class B Acc | 5% |
| Pacific ex Japan Equity | Stewart Investors Asia Pacific Leaders B Acc | 16% |
| Emerging Market Equity | Invesco Perpetual Global Emerging Markets Class Z Acc | 17% |
| UK Property | Legal & General UK Property Feeder I Acc | 5% |
Source: Informed Choice
Patrick Connolly's suggested asset allocation for an adventurous investor
| Asset class | Portion |
| Equities | 75% |
| UK Equities | 25% |
| US Equities | 10% |
| European equities | 10% |
| Asian equities | 10% |
| Japanese equities | 10% |
| Emerging Market equities | 10% |
| Fixed interest | 15% |
| Strategic Bond funds | 15% |
| Property | 10% |
| Property funds | 10% |
Source: Chase de Vere
Managing your portfolio through volatility
Once you have constructed your portfolio to meet your investment objectives it is important to stick to your goals and not react emotionally to short-term market movements.
"Too many people make investment decisions based on short-term performance or sentiment, meaning they often buy at the top of the market when sentiment is positive and sell at the bottom when it is negative," says Mr Connolly. "Investors will achieve better long-term returns and ride through the difficult times by staying calm, adopting a long-term strategy and sticking to it without being distracted by short-term noise."
Changing your asset allocation due to fears over short term volatility can have detrimental long-term effects.
"We suggest trying to trade as little as possible - especially as platforms are quite expensive and you risk dampening long-term returns," explains Mr Boyadzhiev. "For example if you're scared right now and buying lots of bonds, that could dampen the returns you make further down the line. It is better to stick to the portfolio allocation and adjust it strategically."
By rebalancing your portfolio once or twice a year you can ensure you do not take too much or too little risk. Mr Connolly suggests that when you review your portfolio you sell investments which have performed well so represent a larger portion of your portfolio, and reinvest the proceeds into investments that have performed poorly and become a smaller proportion of your portfolio. This will help you get back to your starting position.
"This is particularly relevant during volatile times as the shape and risk profile of your portfolio can change significantly over a short period," explains Mr Connolly.
But Mr Jane favours cutting your losses early and running your winners, only trimming them when they start becoming too large a part of your portfolio. "Selling winners and trying to gain back losses is based on the concept of mean reversion which is disproven by the data," he says. "Rather a loss implies that you have made a mistake."
He weights shares on the basis of how correlated they are to the wider market, with more correlated shares being given a smaller position in the portfolio.
"We will reduce [high performing positions] that are getting more correlated," he says. "What tends to happen is that the market works in waves of optimism and pessimism, and falls in love with positions that weren't correlated with the market before meaning these become more correlated, so when that happens it's a good time to get out of them."
