Why you shouldn't wish away market volatility

Whenever share markets go through a 10% fall - known as a share market correction - most investors tend to worry something really big is going on in the world and their investments will never recover.

Unfortunately, sometimes they panic and hit the sell button, thus locking in those negative returns.

There is no doubt a decline in portfolio value has a far bigger impact on an investor's emotions (about twice the impact) than gains in the portfolio.

History shows that after every single market crisis that has ever occurred, the share market has recovered and gone onto new highs.

These ups and downs are a normal part of markets. In fact, a decline of 10% or more tends to occur within share markets every 18 months to 24 months.

This is simply the market volatility that investors need to accept when they invest in shares.

It's important to keep in mind that every asset class has volatility in returns, and it's not limited to share markets.

Even term deposits - seen as one of the safest investments options - experience volatility. Back in 2011, people could invest in a one-year term and receive about 6% interest return; however 10 years later, that one year term deposit rate had fallen to less than 0.5%.

That is more than a 90% fall in investment returns and pushed many term deposit investors to look for alternative investments.

Interestingly, the Australian sharemarket dividend return is far less volatile than term deposit rates and tends to stay around a 4% income return plus franking credits on top.

It is true that the share market is the most volatile of all the asset classes.

However this is also the reason it produces the highest return of all the asset classes. There is a term known as the risk premium which refers to the higher investment return expected from owning a riskier asset, such as shares, compared to a risk free investment, such as a bank term deposit.

It is quite amazing that over long periods of time, the difference between Australian shares and the cash return tends to offer a 5% a year risk premium.

In fact, for the past 100 years, the Australian share market has averaged a 10% per annum return while the cash rate has averaged 5%.

If this volatility did not exist, the risk premium would not exist and returns would not be higher from the share market. As the saying goes, 'no risk, no reward'.

Perhaps the key to managing this volatility problem is to simply stay invested.

On a one-year investment time frame, investors have about a 75% chance of a positive return from Australian shares (including dividends).

But change this to a five-year time frame and it is nearly impossible to have a negative return from the Australian share market.  The old saying 'time in the market, beats timing the market' will forever hold true.

For those who have requirements for funds in a shorter timeframe - say within the next three years - it is usually best to invest the money in a high earning cash account or term deposit.

For those with an investment period between three and five years, then perhaps having some allocation to shares will help increase the investment returns from the portfolio.

But for many, the investment period is five years plus and so having a large allocation to the share market will provide the best opportunity to maximise returns.

Just don't wish away market volatility as it will wish away higher returns.

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