Authored by Nitin Rao
Market volatility is inevitable. It’s an inherent part of investing. While volatility is associated with every investment class, some of them are inherently more volatile (like equities) than the others (like bonds). Volatility is a statistical measure of the tendency of a market or given security to rise or fall sharply in a short period of time. To put it another way, it represents the extent of price swings of an asset around the mean return.
In most cases, high volatility is associated with high returns. The cryptocurrency market, for example, is extremely volatile. There are stories of people becoming an overnight billionaire and people losing all their invested money. However, beyond a point, even though volatility increases, returns may not increase up to that extent.
Market volatility scares novice investors, making them consider putting all their money back in a bank. However, it is important to know that, highly volatile or not, market movements are cyclic. They can appear erratic, sometimes even falling steeply downward, but all markets eventually bounce back. This is why experienced investors usually focus on long term gains, ignoring short term fluctuations.
A very well-known traditional way of handling volatility is not putting all eggs in one basket. Asset Class Diversification i.e. investing in diverse assets. This strategy is known to minimize risk and maximize returns.
Diversifying within individual investment classes is also recommended. For example, investing in government securities and high rated corporate bonds within debt or diversifying amongst cyclical and defensive sectors and large, mid and small market cap within equities.
Another way of diversifying is to pick investments with different rates of returns (and risks). For example, while investing in bonds, consider bonds with varying credit qualities, duration and maturities. However, diversification isn’t a one-time task. It’s important to regularly keep an eye on the portfolio. So, you can make changes accordingly to align the risk level with your investment strategy.
How to build a shock-proof portfolio?
Here are a few more ways of making your portfolio extremely well diversified and handling volatility, especially in difficult market environments.
Alter strategies according to the market movement
Market patterns often reflect the economic cycles in advance. It is possible to predict expected periods of volatility and take corrective measures in due time. Monitoring markets regularly and recognizing changes in the market movements can help one prepare against market volatility.
If a certain asset is giving higher or lower returns than expected during bull or bear market situations, then it's important to make changes accordingly and rebalance your portfolio. By taking an active approach to risk management, you'll be prepared against unfavorable changes in the market
Efficient asset allocation
An investment portfolio should be a blend of assets, which have low or negative correlations. The idea behind this is to prevent the ongoing market scenario from equally impacting all the assets. For example, it's a good idea to invest both in domestic and foreign stocks to protect your financial goals against local stock market shocks. Stocks issued by foreign companies perform differently since they have exposure to different opportunities in different parts of the world.
Investing in various sector funds
It is wise to invest in stocks issued by companies from different sectors/segments of the economy. The world's greatest investor, Warren Buffet shows you exactly how to diversify when investing in stocks with his top five stock picks being Apple, Wells Fargo, Kraft Heinz Company, BoA (Bank of America) and Coca-Cola. These stocks represent five different companies from different sectors. Since all sectors aren't equally impacted by differing phases of the economic cycle, you’ll be more protected against markets’ ups and downs.
Play defensive if required
If more money is invested in growth stocks, volatility can be addressed by moving to defensives or value stocks or high dividend yield stocks. During unpredictable movements in stock markets, bonds make good "cushion". Although they don't offer very high returns, they are a lot less volatile.
Trading with discipline
It's important to develop discipline and objectivity to be a successful investor. Your time horizon and risk tolerance will dictate your investment decisions. Following a disciplined way of investing, especially in trading, is another way to address volatility. This will prevent you from making reckless decisions in turbulent times.
Market volatility and short-term losses can trigger anxiety among investors. If you have picked the right group of investments, there is no need to worry. It’s best to ignore short term fluctuations and hold on to the investments until financial goals are realized. For a long term investor, volatility is a friend rather than an enemy. Staying the course is not easy, but it will be rewarding in the long term.
Nitin Rao is CEO at InCred Wealth. Views are personal