Volatility can have a profound effect on investment values

This is according to Jacques du Plessis, chief investment officer at AlphaWealth. "Even though we have been in an extended bull market with periodic pull backs, there has been ongoing recovery and the trend has been a stable, progressive upward market. It lulls investors into a lax and dangerous investment pattern."

Du Plessis says volatility may begin spiking more frequently due to factors such as technological advancements, speed of information sharing, 24/7 access to markets, geopolitical factors including sovereign debt levels, central bank intervention into markets, high-frequency trading and current valuation in many markets, in particular South Africa.

The VIX is the global measure of volatility in the market. When volatility is high, risk is high. Currently the VIX is at 12,5. During the global financial crisis in 2008 it measured 89, during 9/11 it reached 49 and in October 2014 the VIX hit 20 on concerns around the spread of Ebola.

To deal with the risks of volatility, AlphaWealth advises assessments with wealth managers to make sure investors are in the right products and risk categories for their requirements.

Diversification is important

"We believe diversification is the only free lunch in the investment world," Du Plessis continues. "Make sure your portfolio is well diversified at multiple levels. For instance, even if you are an equity only investor - you need to make sure there is sufficient diversity, no stock, sector, geography, currency, nor company should dominate. Ideally investors should be diversified across asset classes both locally and internationally including bonds, property and equity."

However for better returns and reduced market risk, investors are advised to consider assets classes beyond just the traditional bonds, property and equity. AlphaWealth advises its high net worth clients to include alternative asset classes such as private equity, hedge funds and real assets like timber and commodities. This plays an important part in reducing volatility, improving long term performance and returns.

Volatility can be extremely unsettling as one day an investor's portfolio is up, the next day it is down. Investor psyche also takes a beating in volatile markets. However, volatility in the investment world not only causes damage to investor emotions, it can cause real damage to portfolios.

The higher the volatility, the more dramatic the fluctuations in value can be. This applies not only to individual investments but also to portfolios as a whole.

Average annual return

Many portfolios are evaluated on the basis of average annual return. Your performance report will show the annual return along with corresponding benchmarks. This is an example of the relative benchmarking or 'what did the market do' type of investing versus absolute return focused investing.

This chart shows how all 7% returns are not the same. Extreme volatility has a real effect on a portfolio. Fluctuation of returns can lead to reduced portfolio growth over an extended period. Large losses take more return and possibly a longer time period to recover. You can't recover a 50% loss to a portfolio with a 50% gain. It requires 100%.

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Sadly, in the example, the investor in Portfolio A may very well have redeemed on two occasions - in year two and year four. However Portfolio A ultimately did better over the period. The investor emotion of missing out on better returns, left them missing out on better portfolio management.

Volatility is a constant but has a tendency to spike periodically, and as shown in the example can have a profound effect on investment values. It is an ever present risk that should not be overlooked.