- Date : 13/10/2021
- Read: 7 mins
Market volatility can neither be eliminated nor avoided, but you can reduce its impact by following various investment strategies.
Volatility is an inherent part of the stock market. While you cannot avoid market volatility, as a trader or investor, you can follow some investment strategies to reduce its impact. This article will focus on investment strategies that can help you tide over an extremely volatile market.
What is market volatility?
Before we discuss the investment strategies for market volatility, let us understand what market volatility is. In very simple terms, market volatility is the up and down movement in share prices and market indices. It measures the speed at which prices change or the degree of price changes. Depending on the time horizon, the movement can be measured daily, weekly, monthly, quarterly, yearly, or over many years.
The lower the market volatility, the higher the returns, and vice versa.
Relation between market volatility and returns
As seen in the above chart, during the market fall of 2008-09, the market volatility was very high. Similarly, during the market falls of 2013 and 2014, volatility spiked. In 2016-17, market volatility was low and Nifty gave very good returns.
Market volatility can neither be eliminated nor avoided, but you can manage it with certain investment strategies. Let us understand some of these investment strategies.
1) Handling volatility by investing in multiple asset classes with low correlation
When two asset classes move in the same direction due to the same event, they are positively correlated. But when the movement in one asset class has little or no impact on the movement in the other, they are said to have low or no correlation. When you have a multi-asset investment portfolio, and one asset class is experiencing volatility and moving down, your portfolio will be balanced by the other asset classes that are doing well.
As an investor with appropriate asset allocation, you should diversify your investments in different asset classes such as equity, gold, debt, etc., that have a low or no correlation. For example, in March-April 2020, the equity markets fell sharply. During the same time, gold gave one of the best returns in the last many years. So, while the equity portion of the investment portfolio suffered, gains in the gold portion of the portfolio protected the returns of the overall investment portfolio.
Inverse relationship between equity and gold
As seen in the above chart, equity had a fall in 2020 due to the COVID-19 pandemic. However, gold gave one of the best returns in a decade and safeguarded investors’ portfolios during the same time.
It is not just 2020. Equity and gold have shared an inverse relationship in many other years as well. In other words, when gold is down, equity supports the investors’ portfolio, and when equity is down, gold comes as the saviour. So, if an investor has a multi-asset class portfolio with low or no correlation among asset classes and one asset class is experiencing volatility, the other asset classes can stabilise the portfolio and protect investment returns.
Apart from domestic equity and gold, you can add international equity, fixed income products, and real estate (through Real Estate Investment Trusts or REITs) to make a multi-asset class investment portfolio. Such a diverse multi-asset portfolio will be able to withstand volatility in one asset class with other asset classes doing well.
2) Handling volatility by diversifying within the same asset class
Next, let us see how you can further diversify within the same asset class to tackle volatility within the same asset class. Within the broader equity market, various segments experience their own bouts of volatility. Sometimes, large-cap stocks experience volatility, and mid and small-cap stocks outperform. At other times, mid and small-cap stocks experience volatility, and large-caps outperform.
Comparison of Nifty 50, NSE Mid Cap 100, and NSE Small Cap 100 indices returns
As seen in the above table, out of the last 16 years, the Nifty 50 Index (represented by large-cap companies) has been the best performer five times, the NSE Midcap 100 Index has been the best performer five times, and the NSE Small Cap 100 Index has been the best performer six times.
Hence, it makes sense to have a presence in large, mid, and small-cap stocks through large, mid, and small-cap mutual funds. It will ensure that when large-cap stocks are experiencing volatility, the mid and small-cap stocks can support your investment portfolio and vice-versa.
3) Handling stock-specific volatility
Now, let us understand how a trader can handle stock-specific volatility. If you are a short-term or medium-term trader, you can use a stop loss to handle stock-specific volatility.
Intraday traders: If you are an intraday trader or a short-term trader, you can look at a 10- or 20-day Moving Average (MA) to place your stop loss. A simple MA is the average of the closing prices for a stock/commodity/currency for a specified number of days. For example, a 20-day MA is the average of the closing prices for a specified period of 20 days. Whenever there is extreme stock-specific volatility and the stop loss is breached, your position will be closed automatically. It will help you protect your losses.
Related: How To Do Intraday Trading Using A Brokerage App
Medium-term traders: If you are a medium-term trader, you could look at a 50- or 100-day Moving Average (MA) to place your stop loss. You can also use other technical indicators to fix your stop loss to handle stock-specific volatility. If you are a derivatives trader, you should buy options rather than sell options or trade futures during times of high volatility. If the market is fluctuating on either side, you can buy a call as well as a put option (straddle strategy). During times of extreme volatility, sometimes staying out of the market until the volatility decreases can also be a good strategy.
4) Riding out volatility by focusing on goal-based investing
For long-term investment goals like a child’s education or wedding, retirement planning, etc., the investment time horizon is usually more than ten years. In such cases, the best way to handle market volatility is to ride it out, focus on your financial goals, and continue investing in your SIPs. The best way to understand this is by looking at the Sensex journey from 1000 to 60,000.
Sensex journey from 1000 to 60,000
As seen in the chart above, the Sensex journey from 1000 to 60,000 was full of volatility. The Sensex fell many times due to local and global issues. But after every fall, the Sensex not only recovered the losses but went on to make new highs.
So, if you are investing for your long-term financial goals, you should ride out the volatility by focusing on those goals and continuing with your SIP investments. In fact, while investing for a long-term financial goal, you should use market volatility to your advantage and increase your SIP investment during every major fall in the market.
If you are a long-term investor and invest in direct equity, consider investing in stocks with growth potential and higher dividend yield. The stock price may go down during volatile times, but fundamentally strong companies either continue with the same dividend rate or even increase it. So, the high dividend yield can help you ride out the short-term volatility.
In this article, we discussed various investment strategies to handle market volatility. But bear in mind that no single strategy will suit everyone. Depending on whether you are an intraday trader, short-term trader, medium- or long-term investor, your strategy for handling market volatility will be different. Even if you are an intraday trader, there are different ways of handling market volatility. If the volatility is just too extreme, the last option for an intraday trader is to sit out the market for some time until the volatility recedes.