Volatility: Friend or Foe?

By Don Friedman | CEO, The Truth About Your Future
January 1, 2025

With P/E ratios stretched and a new administration taking office, it’s more important than ever that, as a financial advisor, you understand and effectively communicate the nuances of volatility to your clients to help them achieve their financial goals.

Is Volatility Good or Bad?

The answer depends on your clients’ objectives and risk tolerance. Day-trading investors try to use volatility to find opportunities for profit thanks to price swings. But for clients with a long-term perspective, volatility can be scary – because daily fluctuations can appear to interfere with their goals. And no investor likes to experience losses, no matter how fleeting. Your job, then, is to teach your clients how to shut out the noise and remain invested for decades.

Can We Tame Volatility?

The only way to eliminate volatility is to avoid investments that are subject to it. But that leaves your clients relegated to bank accounts and T-bills – which are guaranteed to lose money net of taxes and inflation. That’s why there’s no choice but to seek higher returns – and means we’re forced to invest in asset classes that are subject to volatility. Therefore, rather than trying to avoid volatility, the key is to effectively manage it.

And you can do that via diversification, rebalancing and dollar cost averaging. Encouraging clients to invest across multiple asset classes, sectors, and geographies can help reduce the impact of any single asset’s performance. Additional tools, such as options and structured products, may also help protect against sudden and extreme market movements.

How Is Volatility Measured?

It’s important that you explain to your clients how volatility is measured, to help them understand and get comfortable with it. Three common metrics are standard deviation, beta, and Sharpe ratio. They are easy to explain and understand – and they can help you add value to your client relationships. Standard deviation measures how much an asset’s price fluctuates from its average price; the higher the number, the greater the risk. Beta measures the degree to which an asset’s price moved in sync with the overall market; a beta of greater than 1 means the asset’s price moves more than the overall market, while a beta below 1 is less volatile. And the Sharpe ratio measures risk-adjusted returns, helping clients see if they are being compensated for the volatility their portfolio is experiencing. The higher the Sharpe ratio, the better.

What Is the Right Amount of Volatility for a Client’s Portfolio?

Talk with each client about their goals, risk tolerance and investment time-horizon. For example, a retiree reliant on monthly income might not be able to withstand – financially or emotionally – even moderate volatility. Conversely, younger clients who don’t plan to need access to their money for decades might be more comfortable with higher volatility.

When to Have the Talk

As a financial advisor, it’s important to explain volatility when you establish the account. This way, your clients won’t be surprised when market fluctuations occur. By framing volatility as a routine part of investing and incorporating strategies to help them balance risk and reward, you can help your clients stay focused on their long-term objectives, regardless of market conditions.