How can investors best manage volatility in their portfolios?

When we set out on a long journey, the mishaps and inconveniences along the way are often things we want to forget as quickly as possible. Once we reach our destination, our brains tend to overlook these details the traffic, the bad weather, the delays, the discomfort. Yet when we are stuck on the motorway or waiting for a flight that is already hours late, it can feel as though there is no other problem worth our attention.

For investors, a similar logic applies. In hindsight, the final outcome of an investment plan is what matters most, but the journey also counts, especially when things do not go according to plan.

This aspect is not always recognised by investors. If you have ever asked someone how their investments are performing, you have probably asked “How much has your portfolio grown?” Focusing on performance is perfectly logical, but it only captures half of the story. The other half is called volatility, an equally important aspect of investing whose management is often overlooked or taken for granted, particularly by non-professional investors.

Technically, volatility is a statistical measure indicating how much the performance of a portfolio fluctuates and deviates from its average over time. From an investor’s perspective, it represents perceived risk – how variable portfolio performance is. In other words, how quickly a portfolio grows during positive phases and how quickly it loses value during negative ones.

At Moneyfarm, volatility is one of the key variables around which we have built our advisory philosophy. Our investment portfolios are designed to remain, over the medium term, within defined volatility ranges. Each portfolio is then recommended to investors whose profile and needs align with that level of fluctuation.

We believe that controlling volatility is the most effective way to truly respect an investor’s risk appetite.

But the benefits of this approach go beyond simply reducing real and perceived risk they affect investment performance over time, the psychological management of difficult market phases, and the freedom to access your wealth when needed. In this article, we explore some of the less discussed aspects of the relationship between volatility and investing.

Controlling volatility to avoid impulsive decisions

Investors know that portfolio fluctuations, particularly during negative phases, can become a source of stress and concern. When markets fall, the impact on portfolio value can be significant.

Investors also know that historically, over the long term, positive market phases have outweighed negative ones and that staying invested has often proven to be a winning strategy for navigating difficult periods.

However, simply being aware of these principles is not always enough to reassure investors when they experience market corrections in their own portfolios – especially if they invested at an unfortunate moment. If volatility during downturns feels too high, the resulting anxiety may lead to emotional and impulsive decisions, such as selling investments and turning a temporary loss into a permanent one, or reducing future investment contributions.

When this happens, the emotional decision is often the result of a lack of a clear strategy at the outset – for example, investing in a strategy with a level of volatility higher than what the investor is comfortable managing.

This phenomenon has a precise name the behavioural gap – the difference between the theoretical return of an investment and the return actually realised due to emotional decisions.

According to Morningstar’s Mind the Gap 2023 research, which analysed investor behaviour in funds, this gap eroded between 18% and 27% of total returns over the decade from 2013 to 2023.

We believe that careful volatility management, combined with selecting portfolios aligned with an investor’s risk profile, can help reduce the risk of emotional decisions that may prove very costly.

Lower volatility means smaller maximum losses

Another key metric closely related to volatility is maximum drawdown. This measures the largest drop in portfolio value from peak to trough over a given period.

For multi-asset strategies, maximum drawdown usually has a linear relationship with portfolio volatility less volatile portfolios tend to experience smaller drawdowns, while high-volatility portfolios tend to produce deeper and more frequent declines.

The chart below shows the difference in maximum drawdown between an all-equity portfolio (green line) and a less volatile solution such as multi-asset P5 portfolio (blue line).

As shown, although the equity-only solution would have delivered stronger long-term performance, during negative market phases the diversified solution held up better, protecting investment value and reducing drawdowns.

Why is this important?

When discussing maximum drawdown, it is important not to confuse its meaning. It is a metric based on past portfolio performance and therefore cannot guarantee future losses will be limited.

However, it is still a statistical measure that can help indicate how a portfolio might behave during turbulent market phases (although outcomes depend on the characteristics of the downturn and the portfolio structure).

For this reason, it is also one of the metrics we consider when recommending a portfolio. During the advisory process, we assess each investor’s ability to tolerate losses and only suggest portfolios that – based on our estimates – have volatility and drawdown levels consistent with their capacity to withstand losses, even in extreme market conditions.

Volatility drag how excessive volatility can hurt long-term performance

Volatility is not only a measure of risk it can also negatively affect long-term returns.

This effect is not entirely intuitive and arises from what appears to be a mathematical paradox. A 10% loss followed by a 10% gain does not bring an investment back to its starting point. This is because the base on which the 10% gain is calculated after a loss is lower than the original investment value.

To illustrate with an extreme but simple example recovering from a 50% loss requires a 100% gain.

This means that when negative performance occurs, some value is effectively lost due to volatility. This effect, known as volatility drag, accumulates over time, eroding the final value of a portfolio – more significantly the higher the volatility.

To illustrate the potential long-term impact, consider two portfolios worth £100,000, both with an expected return of 5%, but with different levels of volatility

• Portfolio A expected return 5%, expected volatility 7%
• Portfolio B expected return 5%, expected volatility 14%

The chart shows the distribution of final wealth after 10 years across different market scenarios. The median expected value of Portfolio A is around £160,000, while Portfolio B reaches roughly £150,000.

A difference of £10,000 (10% of the initial capital) attributable solely to the difference in volatility. From a portfolio management perspective, this suggests that at the same expected return, choosing a diversified solution may lead to better outcomes in typical market conditions.

Entry and exit timing and sequence risk

Another risk linked to excessive volatility is sequence risk, which particularly affects investors who need to withdraw money from their investments.

When withdrawing from a portfolio, the long-term value of the remaining investments depends not only on absolute returns but also on the order in which those returns occur.

A negative return just before a withdrawal can have significant long-term consequences. Similarly, a negative period in the early years of a withdrawal plan can be far more damaging than an equivalent loss at the end.

This is because withdrawing funds after a decline locks in losses, preventing the withdrawn portion of the investment from benefiting from any subsequent recovery.

This is illustrated in the case study below. The chart shows the performance of two portfolios over time, from which 5% of the initial capital is withdrawn each year.

The average annual return in both simulations is the same, but the sequence of returns differs. In the red line, which reflects a real investment plan starting in 1999 during the dot-com bubble burst, negative returns occur early on. In the blue line, the sequence of returns is simply reversed.

As shown, after 25 years the blue portfolio is three times larger than the red one, despite both simulations having the same average return.

Sequence risk is amplified in high-volatility portfolios, and one of the best ways to reduce it is to keep volatility under control.

This information is not only relevant for those who regularly withdraw from their investments. Anyone may need to access their invested savings unexpectedly. Keeping volatility under control reduces the likelihood that a withdrawal will compromise the long-term value of the portfolio, providing greater confidence that savings will be available when needed.

There is no “good” or “bad” volatility what matters is controlling it

Volatility should not be viewed as the enemy of investing. During positive market periods, it is volatility that generates returns.

However, ignoring it can be costly – not only in terms of performance, but also in terms of poor decisions made under pressure, reduced financial flexibility, and investment journeys that end before reaching their destination.

At Moneyfarm, managing volatility is one of the core objectives of our investment process and philosophy. We achieve this by constructing portfolios with controlled levels of volatility designed to remain within defined limits over the medium term, while ensuring consistency between that level of volatility and the investor’s risk profile.

Please remember that when investing, your capital is at risk. The value of your portfolio with Moneyfarm can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance. The views expressed here should not be taken as a recommendation, advice or forecast. If you are unsure investing is the right choice for you, please seek financial advice.