Volatility: An ally rather than an enemy

The stock market is an uncertain arena to be in, and thus volatility is inherently built into its nature. A large number of events keep impacting the stock markets time and again. These can be classified as: 'Known knowns' and ‘Known unknowns’. The former relates to things we know about, for eg. an IPO issue period, whereas the latter relates to things we cannot be aware about, for eg. the listing price of an IPO. Lastly, there is another third category of the 'unknown unknowns' which are things we do not have any clue about, like the demonetization exercise, which happened unexpectedly. As the degree of unknowns increases, so does the volatility of the markets. It is a matter of fact that we live in an uncertain world, where volatility is a reality.

This might lead one to wonder, is volatility a good thing or a bad thing? Well, if volatility is here to stay, then why not make it your friend!

The recent history of the world economy has shown a large number of ‘unknowns’ taking place, whether it be the Indian Army surgical strikes, the U.S. Presidential election results, the demonetization exercise or even the North Korea bomb threats. The market’s reaction to each of these events has been sudden and inflated. A large number of risk averse and impatient investors could be seen exiting the market by quickly selling their stocks and booking losses. Whereas, on the other hand, smart investors could be seen using these sell offs as an opportunity to buy good quality stocks at an undervalued price.

In the words of Warren Buffet, world-renowned Market guru, "The stock market is a device for transferring money from the impatient to the patient." One must see volatility as an ally rather than a liability. Instead of fearing it, one should use it to identify correct opportunities to enter the stock market.

Here are a few ways to leverage volatility to your advantage:

Focus on the long-term picture: The market moves in cycles, it goes up, then down and up again. Due to this, in the short run, the market appears to be unpredictable and cyclical in nature. However, if one zooms out and views the long-term chart, one would find that the long term trend shows a continuous rise.

An investor who invests for a short period is unable to earn decent returns if he rides the down cycle of the market. In order to earn good returns on his investment, one must participate in an up cycle of the market and remain invested till the end of the cycle.

One must keep in mind, that these cycles are not visible as clearly and as easily as spoken. Due to the high degree of uncertainty, it is difficult to gauge the start or the end exactly. However, as an investor, it is important to be patient. History shows that the best returns of stock markets have been seen in the long run. A smart investor would be able to create wealth either by staggering his investments by SIPs or by identifying and quickly reacting to market movements which are not structural or fundamental.

'Investing though an SIP' and 'buying on dips' are the two most effective ways to beat uncertainty and volatility.

Ensure safety by keeping a margin: The stock market is never stable. It swings from one extreme to the midpoint and then to another extreme, just like a pendulum. Hence, one needs to understand these movements and act quickly, so as to shift from overvalued stocks to undervalued ones. This would help protect capital and maximise returns.

It is important for an investor to keep a Margin of Safety while investing. What is this Margin of Safety? It is defined as the difference between the fundamental value and the market price of the stock. Higher the fundamental value compared with the market price, higher is the margin of safety. What this means is that you buy a stock not when the price is just equal to the exact value of the assets it reflects, but is significantly lower.

This concept was popularised by Benjamin Graham, the author of The Intelligent Investor. Margin of safety gives enough room for an investment to give returns and protects one in case his assumptions and future estimates turn out to be incorrect.

Look beyond the stock price, dig deeper: We must keep in the mind that the value of an asset is determined by its fundamental parameters.

However, investors are seen reacting to price movement of the stock rather than its fundamentals. For eg, if one bought a stock at Rs. 200, and its price fell due to unrelated and extraneous factors to Rs. 150, investors would be seen getting fearful and selling the stock. Is this the right step to be taken? No. Investors must realize that the fundamentals of the asset are still intact. This fall in price should be seen as an opportunity to accumulate more of the stock at a lower price i.e. discount.

Instead of being absorbed by the price of the stock, investors should look at the valuations and the fundamentals of the security while investing. P/E, P/B, PEG and dividend yields are a few techniques which can reflect the true value of the stock. The best approach, however, would be to combine these methods of valuation, so that one can get a better view of a stock's worth.

Diversification is a must: Warren Buffet advises: Don’t put all the eggs in one basket. The meaning of this advice is very important to understand. Concentration of investments under any particular asset class can be injurious to wealth. One must follow proper diversification between financial assets and physical assets in order to reduce risk.

Diversification should be done keeping in mind the risk appetite of the investor as well as the return he or she expects. Preferably, higher allocation should be given to financial assets with equity being the most favoured asset class. This is because it has been seen that in the long run equity has outperformed all other asset classes. Diversification also helps to ensure predictability of returns as it helps one asset class compensate for another’s performance. When one asset price moves down, the other asset’s price could most likely move up, compensating for the former. This helps investors to negate uncertainty.

Within asset classes as well, one must diversify to protect downside risk. For example, in the case of equity, the stocks in one’s portfolio must show representation from different industries as well as different market capitalizations. Similarly, in debt markets, diversification should be done over different tenures and types like FDs, bonds, company fixed deposits and NCDs. This helps to reduce correlation between the performances of the different components in the portfolio.

Think before you act: The time difference between the receipt of news of a stock and its analysis and execution has been reduced to seconds. Reaction to news is reflected very quickly through the movement in the stock price, leading to the markets acting volatile. While it is necessary for short-term traders to react this way, long term investors must not act impulsively. They should respond gradually after analyzing the impact of the news on the fundamentals of the investment.

One should make sure and verify if an event structurally affects the investment or not. Long-term investors should ensure they invest in stocks with a strong fundamental and structural story and not concern themselves with short term ups or downs. In Warren Buffet’s words “only buy something that you'd be perfectly happy to hold if the markets shut down for 10 years.”

Volatility should be seen as an opportunity during times of uncertainty. It should be used to create wealth by taking a positive cognizance of events. It is important for one to embrace volatility and be mindful to respond to events by taking a more holistic approach rather than reacting to them impulsively.