Welcome to our Demystifying Investment series, which aims to simplify investment must-know terms essential to making investment decisions. We hope you have familiarized yourself with the last part that dejargonized the Sharpe ratio.[1] In this part, we will shed light on market volatility and investments strategies to tide over extremely volatile markets.
Understanding Market Volatility
“Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.” - Warren Buffett
A stock’s volatility is a measure of its tendency to go up or down within a timeframe. It is the spontaneous increase or decrease in its value measured mathematically as its ‘standard deviation’ from the average or expected value and represented by the symbol "σ. “ The higher the price change in any direction, the higher is its volatility.
However, higher volatility does not imply higher risk. Risk is the possibility of losing money without any gains, while volatility is the possibility of losing money or making a profit.
Consider two stocks, X and Y; if the price of stock X varied between +8% to -10% and that of stock Y varied from +5% to -5% in the same year, stock X was more volatile than stock Y. Simply put, higher market volatility means you can potentially make a higher than expected profit or run the risk of making a larger than expected loss.
What Causes Market Volatility?
The most common and obvious reasons that cause volatility in stocks and indexes include:
Investor Sentimentality
The sociopolitical sentiments of investors drive them to buy or sell in markets and create unfathomable volatility.
Critical Events
Stocks or markets are always found to be moderately or even significantly volatile around the time of crucial events, such as personnel changes, controversial financial news, changing expert opinions, announcements of mergers, buyouts, or initial public offering (IPO), etc.
Ease Of Trading
One current factor that has declined market stability is the increased participation in the markets due to easy access to real-time trading accounts, market news, and forums through apps and social media. What amateur online traders were able to do with the GameStop stock last year is the best example in this aspect.
Social Catastrophes
A national or global-level issue always spooks investors into revamping their portfolios across sectors. The COVID-19 pandemic caused similar turmoil, and the hospitality stocks took a major hit. Back in 2008, the banking market suffered from similar losses for a long time due to investor skepticism.
Calculating Volatility
Fund managers use different methods to calculate either an individual stock’s or a market’s volatility. Following are the two common metrics used by US market investors.
Beta Metrics:
Beta measures a stock's historical volatility relative to the S&P 500 index. (Source)
● If a stock’s Beta is more than one, let’s say 1.5, it is expected to increase by 1.5% if S&P500 increase by 1%.
● If a stock’s Beta is less than one, it is expected to not react to the S&P500 value.
● If a stock’s Beta is negative, let’s say -1.5%, it can be expected to move opposite to the S&P500 value.
VIX Metrics:
A market’s volatility can be judged by the Chicago Board Options Exchange (CBOE) Volatility Index (VIX). Investors can directly refer to its value to predict the fear level among investors. A higher VIX value would indicate increased fear of massive stock price movements over the next 30 days.
How Investors Should React In Volatile Markets To Maximize Returns
There’s a famous quote, “For the investor who knows what he is doing, volatility creates opportunity.”
As an investor, understanding the volatilities in your portfolio helps you better analyze market risks and choose the right investment options. If two funds A and B have offered the same percent return over a fixed period, you can learn which fund endured less volatility to suit your risk appetite. This, in turn, will help you devise the most beneficial investment strategies to maximize your returns.
Here are some of the expert-backed strategies that investors can utilize during highly volatile times.
Buy & Hold Strategy
You can avoid the effects of volatility altogether by holding your investments for long terms. That way, you also get the opportunity to buy more stocks when a stock dips and multiply your returns. It is mostly recommended for young investors with a long work life ahead of them.
Fixed Income Investments
For investors who are too old or less interested in taking on long-term risks, moving to fixed income funds and government bonds is always an easy option.
Diversification
Each market sector is affected differently during volatile situations. Hence, diversifying your securities portfolio across sectors and markets can help.
Trading on Volatility
You can even capitalize on market volatility by trading ETFs that track a volatility index, such as the Volatility Index (VIX) by Cboe mentioned above.
Seeking Help From The Pros
Seeking such expert help can let you focus on scaling your portfolio without having to track each and every investment. Our ‘War & Peace’ portfolio, for example, provides capital growth and preservation for the conservative investor, without compromising on returns.
Moving Forward
By learning the intricate nature of stock markets and how volatile they may become, you can construct a portfolio that fits your own investment goals. Another factor that you may have to analyze closely is the risk-adjusted return your portfolio offers. Knowing the relative risks involved in your investments and the expected market volatility can help you make the smartest investment decisions.
So head over to this article to learn more about risk-adjusted returns and the role of the Sharpe ratio.
References