Volatility in markets is best understood by the fluctuations or the variance in returns. Over the last few years the NSE publishes the VIX (Volatility Index), which shows how the volatility in the stock markets is moving. The crux of the matter is that volatility is a measure of risk and this risk constitutes the second important dimension of investing after return. In fact, it is your risk appetite that eventually determines your investment mix. Risk is so important that the celebrated writer, Peter L Bernstein, in his landmark book, 'Against The Gods', specifically mentions that "The real reason for progress in the 20th century is due to our ability to understand, measure and manage risk more effectively".
Risk in markets is best understood in terms of volatility in markets. Now, what causes volatility? There are a variety of factors. Firstly, domestic valuation concerns can cause volatility in the markets. Similarly, a preponderance of traders trying to punt the markets can also cause volatility. Secondly, government policy can cause macroeconomic certainty and lead to volatility in the markets. Thirdly, global events also play a key part. For example, the Fed rate moves, China trade numbers, geopolitical risk of North Korea and West Asia; all these factors contribute to volatility. The logical question, therefore, is what should be y our investment strategy in such volatile markets. You should actually adopt a 5-pronged strategy.
Diversify your risk across asset classes..
On rare occasions, like in 2008 post Lehman, we have seen all asset classes losing value. In other times, you can diversify your risk by moving to assets that are less or negatively correlated with equities. Parking your money in a debt fund or government bonds is one option. If you are just looking for a temporary shield against volatility then you can also look at liquid funds that may offer lower returns but can give you instant liquidity without any liquidity costs. Remember, shifting out of asset classes and shifting back to them has transaction cost implications and also tax implications. You must therefore assess the merits of such a shift in post tax terms to be really meaningful.
Let your equity funds be parked in less cyclical sectors..
When markets become volatile, what are the sectors that are most likely to get affected? Typically, in any event of macroeconomic volatility, it is the banks and financials that get immediately impacted. If it is a valuation related volatility then try to stay out of the sectors and stocks that have triggered this volatility in the first place. IT in the peak of 1999, Realty in 2007 and PSU banks in 2011 are all cases in point. Capital goods stocks are vulnerable when the capital investment cycle is turning negative. In times of heightened volatility, try to stick to the sectors that have strong brands and high ROE. These stocks are likely to weather the storm much better. Typically, FMCG companies and pharma companies tend to fall in this category.
Increase your exposure to gold..
If you track the price of gold, it follows a very curious pattern. It normally tends to outperform other asset classes when the uncertainty surround the macroeconomic or geopolitical situation is the highest. Look at some classic examples. Post 1981, gold saw a 10-year rally when the price of gold actually went up 30 times due to global geopolitical uncertainty. Then, post the Lehman crisis, gold again went into a major bull rally which lasted all the way up to September 2011. Lastly, we saw gold outperforming other asset classes in early 2016 when the macroeconomic uncertainty was high globally due to the Fed decision to hike rates for the first time. In any event of high volatility, gold becomes the preferred safe-haven asset. Today, there are options to own gold in a variety of forms including gold bonds, MMTC Digital gold, gold ETFs and gold futures; apart from physical gold.
Beat volatility with options by combining insurance and leverage..
This is slightly more complicated compared to the other techniques but in a financial market that is getting increasingly complicated and sophisticated, you must learn to use these instruments. In fact, options not only help you tide over the volatility but also help you to make money out of it. Let us see how! A very simple way to reduce the impact of volatility is to use put options to hedge your downside risk. What these put options do is to help you compensate for the notional loss in your portfolios. That is passive; but you can also participate actively. There are volatile trades like straddles and strangles where you do not need to predict the direction of the market but you will benefit from volatility either ways. Options are low risk / low investment products which you can effectively use to beat market volatility.
Last, but not the least, don't lose perspective on your financial plan..
The most important imperative in volatile times is not to lose perspective on your long term financial plan. Remember, stock markets have done extremely well over the long run. If you consider the last 15-20 years, those who have held on to stocks or equity mutual funds have made a huge pile of money. This is despite the 5-6 bouts of volatility that these investments have had to go through. The moral of the story is that even as you make your short term plans to handle volatility, don’t236_HP lose sight of your long term financial goals.
Volatility is part and parcel of participating in the market. As smart investors, you need to do your best to protect yourself against volatility. Above all, don’t let this volatility gloss over your long term goals!