How to diversify in the time of market volatility

Volatility is a method of understanding the movements of stocks in the market. It was used to identify the impacts of stocks under certain situations. There are many methods to diversify stocks during high volatility. This article covers Volatility, diversification, and how volatility impacts returns.

What do you mean by market volatility?

Market volatility describes changes in any security valuation, as we all know that the stock and bond markets are uncertain. If stock prices undergo drastic changes within a short span, they are termed ‘High market volatility’. Changes can be upwards or downwards. If stock prices do not undergo significant fluctuations and remain at the same level, they are termed a ‘low volatility market’.

Market volatility estimates fluctuations in securities market prices. It is calculated as the 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 consider market volatility 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 market sentiments drive the security price or when investors are unsure about a company's future. It occurs when there are sharp and frequent movements in the asset's performance.

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 the 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 During Market Volatility?

There are many methods to diversify volatility. Let's determine which method suits you best for diversifying your portfolio in different circumstances.

Short-Term volatility

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 volatility will stabilise with time. 

Hedging 

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 securities, meaning a fall in one stock price might lead to a rise in another, thereby covering the investor from the loss. While hedging is a beneficial tool, it comes with its own risk when there is overall stress in the market, like during the COVID-19 pandemic.  

Techniques to avoid short-term volatility

Invest for the long term:

Investing in the long term, which is usually any period above 8-10 years, automatically eliminates the effects of short-term market fluctuations.

Past trends have shown that if an investor stays invested for the long term, good returns are expected. Though past performance cannot always guarantee future performance, markets usually bounce back. 

The most common mistake investors make is withdrawing from mutual funds when the market is unstable and declining. Withdrawing funds during all short-term fluctuations will not help them achieve their investment objectives.

By stopping your SIP, you miss out on the advantage of compounding. Remember 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 investment fluctuations. This practice will help 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. They 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 purchasing 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 the risk of entering the markets at the wrong time. 

Invest in different market instruments:

The key to safeguarding 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. 

If one tries to time the markets and invest in a lump sum, one could suffer massive losses, and the markets could fall further. If one has to spend a lump sum, one has to pay progressively while seeing how the situation progresses.

Conclusion

Volatility will be always there in the market it will change on day to day basis some days it will be high and some days it will be low do proper research and keep your portfolio diversified and use derivatives wisely to hedge the polio correctly in the market down fall you can safeguard your holdings and in some cases you can make profits as well.