If you are already an investor or a first-time investor, you have likely heard the term ‘market volatility. So first, let us understand this term in brief.
What do you mean by market volatility?
Market volatility describes the changes in any security valuation as we all know that the stock and bond market are uncertain. If stock prices undergo drastic changes within a short span, they are termed as ‘High market volatility’. Changes can be upwards and downwards. If the stock prices do not undergo any major fluctuations and remain at the same level, they are termed as ‘low volatility market.’
Market volatility is an estimate of fluctuations of securities market price. It is calculated as an average difference between the range of the securities highest and lowest prices over a specific period.
How will market volatility affect the return on investment?
Many investors take ‘market volatility as a risk factor for investments. However, it pertains to how the stock or bond price will react to a risk event.
High volatility is usually observed when the market sentiments drive the security price or in case there is a lack of clarity to the investors where a company is headed. High volatility is when there are sharp and frequent movements in the performance of the asset.
Market volatility can give investors the impression that they are losing their money. And that is why many investors withdraw from mutual funds when they see that money is not working. This step damages your investment intentions as financial performance can go back and, in the long run, can bring you huge profits. Therefore, it is always advisable to invest for at least five years to get a good return.
How to diversify at the time of market volatility?
The short-term volatility can be temporary, and as an investor, one should not bother much about it. This is because it is for a limited time and can also give good returns. Short-term volatilities shall stabilise with time.
Before we discuss diversification, let us understand the difference between hedging and diversification. Both are different approaches and would affect your portfolio differently. Diversification usually refers to investing in securities that are not correlated with each other. Correlation explains how a fluctuation in one stock or security might affect the stock prices of other stocks. Correlation can be positive, negative or no-correlation. Hence, an investor should consider the impact of correlation while diversifying.
Hedging refers to investing in negatively correlated security, meaning a fall in one stock price might lead to rising in another, thereby covering the investor from the loss. As hedging is a beneficial tool, it comes with its own risk when there is overall stress in the market, like the times of COVID pandemic.
Techniques to avoid short-term volatility
- Invest for long term-Investing in the long term automatically can eliminate the effects of short-term market fluctuations. The long term is usually any period above 8-10 years. Past trends have shown that if an investor keeps invested for the long term, good returns are expected to be received at the end. Though past performance cannot always guarantee future performance, markets usually bounce back. The most common mistake investors make to withdraw from mutual funds when the market is unstable and declining. Withdrawing funds in all the short-term fluctuation will not help them achieve their investment objectives. By stopping your SIP, you miss out on the advantage of compounding. Do not forget that equity yields the best returns in the long run, so adhere to it.
- Review of the portfolio in intervals: An investor should review the entire investment portfolio at least once a year to evaluate any long term fluctuations in investments. This practice will help you to counteract the effects of instability.
- Invest through SIPs-SIPs are a way to invest in the market to overcome the effects of short-term market volatility. SIPs enable an investor to invest a fixed amount at specific intervals regardless of the market situation. SIPs use rupee cost averaging, wherein the units’ cost price is averaged out by way of purchase of more units when the prices are low and fewer units when they are high. Also, choosing the SIP option is a great way to diversify investments without having the risk of entering the markets at the wrong time.
- Invest in different market instruments-The key to safeguard your portfolio is diversifying it across various market segments and instruments. Hence, an investor should choose a combination of equity, debt, fixed deposits, etc. By doing this, the volatility risk of your equity funds will be covered by the fixed income return from debts and fixed deposits.
- Avoid investing a lump-sum amount-Investing in a lump-sum amount is not a good idea. If you feel that the prices are extremely low, and it seems like a lucrative opportunity to invest in a lump sum, it can be risky to believe that the markets have hit rock bottom. One could suffer massive losses if you try to time the markets and invest in a lump sum, and the markets fall further. And if you have to spend a lump sum, you have to spend progressively while seeing how the situation progresses.
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