What do we understand by market volatility? To put it in technical terms, market volatility is all about the standard deviation of the stock market returns from the mean. In layman’s terms, volatility is the gyrations of the stock market. Why is market volatility important? There are 3 reasons for its importance. Firstly, market volatility is a measure of risk, so greater the volatility greater is the risk in the market. Secondly, volatility cannot be prevented but it only has to be managed. That is where your volatility strategy comes in handy. Lastly, there is an inverse relationship between volatility in the stock market returns. Lower the volatility, higher the returns and vice versa. Consider the chart below..
Source: Bloomberg
If you compare the Nifty index with the VIX, which is the volatility index, the sharp rally in the Nifty post 2009 has been marked by a consistent and secular fall in the VIX. Similarly, when the VIX touched a peak in 2008, the Nifty had made a long term bottom. The question, therefore, is how to deal with stock market volatility? Since volatility cannot be avoided altogether, how should you go about investing in volatile markets? Here are 5 strategies for volatile markets; which are simple yet actionable.
1. Don’t abandon your financial plan
That is something you need to remember first and foremost. If you look at the VIX chart over the last 9 years, it has been a secular down-graph. But if you look in the interim period, there have been at least 8-10 occasions when the volatility has spiked substantially. The basic idea is not to abandon your long term financial plan. This plan is directed towards your long term goals and has some inbuilt checks and balances to handle volatility. For example, the systematic investment plan (SIP) is designed to make the best of market volatility. Since your SIPs form the cornerstone of your financial plan, they are essential to ensure that the power of compounding works in your favour. If you look at the performance of SIPs historically over the last 9 years, they would have substantially outperformed the index since they have made the best of market volatility.
2. Overweight on quality; underweight on risk
This has specific reference to your equity and equity mutual fund portfolios. When the markets are on a bull run, you do tend to load up on mid-caps, small caps, sector funds, thematic funds etc. Never take on too much concentration risk when the markets are volatile. Secondly, focus on stocks that have traditionally exhibited high standards of transparency and corporate governance. They are your best bets in a volatile market. Thirdly, focus on higher growth stocks, high margin businesses and market leaders within the industry. They are the most likely to outperform in the midst of volatile markets.
3. Use Futures and options to your best advantage
Many investors look at futures and options as a low margin alternative to cash market trading. Actually, they are excellent risk management products. It is in volatile markets that you should make the best use of these derivative products. For example, when you are long on equities in a volatile you can use futures to lock in profits and also get the benefit of roll premiums. Secondly, you can also use put options to hedge your risk and you can also do beta hedging with index futures to hedge the risk of your portfolio. If you are willing to be a little more adventurous and aggressive, you can also look at volatility strategies like straddles and strangles to make the best of volatile markets. You really have a wide array to pick in volatile times.
4. Stay diversified in your asset mix
How do you manage your asset mix when markets are volatile? There are certain assets that do not display the same degree of volatility as equities during volatile times. For example, debt markets tend to be more stable when equity indices are volatile. So debt in your portfolio adds stability and the assurance of regular income. Similarly, gold tends to normally benefit from macroeconomic volatility. So increasing you exposure to gold via gold ETFs can also be meaningful in these volatile times. The moral of the story is to stay diversified in your asset mix to beat the volatility.
5. When in doubt, just do nothing
Traders normally believe that there are two strategies to master in trading viz. when to buy and when to sell. Actually, there is a third strategy; when to do nothing. In volatile times, it is very easy to be lured into the market by the temptation of fishing in troubled works. The basic rule is that when you do not understand the undertone of the market, it is best to stay out of the market. In volatile markets, staying out at the right time and doing nothing can also be an important part of strategy!