Volatility is the statistical stratagem of fluctuations in the price of an asset. In 1953, Nobel Prize-winning statistician Henry Markowitz acquainted the concept of volatility as a measure of investment risk. Volatility is of prominent importance to dealers in the stock market, notably those who trade in derivatives (futures and options). Though, volatility and risk have very diverse connotations for investors. Customary investor Warren Buffet said, “Volatility is far from compatible with risk. Risk comes from not understanding what you are doing”.
In this article, we will try to understand what causes volatility, what impact it has on the equity market, mistakes to withdraw in volatile markets, and how you should ride volatilization.
What induces volatility?
You can see in the chart below that the stock market experienced several deep corrections in the past 20 years. However, it is essential to note that Nifty 50 TRI shrank 11.6% CAGR returns over the last 20 years. Let us seek to understand the conditions of volatility.
In the short term, volatility is caused by inequality between buyers and sellers in the stock market. If there are more traders than buyers in the markets, the stock prices will decline and vice versa. Change in risk sentiments creates this unevenness. Uncertainty about the future viewpoint is the primary reason behind the increment in risk objection. The most recent model of excessive volatility caused by sudden risk aversion is the market crash in March 2020 caused by the fury of the COVID-19 pandemic – Nifty fell by 35%. Volatility can be created by other factors as well.
Political uncertainty: In India, markets have responded to political uncertainty. The market declined more than 20% after the Lok Sabha election of 2004. The market was anticipating the NDA win, but the UPA Government came to influence. However, the market quickly recovered and favorably, we have had stable Governments in all the preferences after 2004.
Economic Crisis: Stock markets are very receptive to economic situations. Bigger the crisis, the bigger the breakdown in the market. The market crash in 2008 as a result of the Global Financial Crisis, the early 2000s bear market caused by the global economic retardation in the aftermath of 9/11, and the correction of the year 2011 are examples of the impact of economic retardation/recession on stock markets.
Change in Government policy: Demonetization is an example of volatility in the market created by uncertainty about the byproduct of the Government’s policy on the economy. Market volatility following the Government introducing the tax surcharge on FPIs in the interim Budget of 2019 which was consequently succeeded back is another example.
Global events: With growing global integration, global events also affect the stock market. The improvement in FY 2015 – 16 was largely driven by global factors like the Eurozone debt crisis, economic retardation in China, etc. The lately concluded US Presidential elections are another example of the influence of global effects on the stock market. India was also influenced by the bout of global volatility in the run-up to the US Presidential election.
The velocity of improvement depends on a variety of volatility. For example, volatility caused by volatile demand and supply irregularity is usually short-lived and the market recovers reasonably quickly. On the other hand, the market takes longspun to recover from rigorous economic downturns or withdrawals.
Influence of current events on stock market volatility
The Nifty dropped nearly 500 points in the two weeks before the US Presidential elections. We saw notable intraday volatility during this season. However, the market has embraced the results of the US elections. Nifty has increased 900 points and is presently at its all-time high since the results revealed a clear pathway to victory for the Democratic presidential candidate. Though the Republicans have registered lawsuits in various states challenging the election results, most market experts anticipate them to not have any effect on the stock market. Bihar assembly election is a different important event on the political calendar, but sentencing by the market’s response to the exit polls, it may not have a meaningful impact. As far as COVID is disquieted, despite concerns about another wave of infections, the market reacted favorably to the positive news on the vaccine beginning. Though the condition of the market appears positive, there may be lingering affairs about volatility due to the COVID condition and the economic consequence thereof.
Should you be concerned about volatility?
Let us revisit Warren Buffets' quote about volatility and uncertainty not being compatible. Volatility refers to ups and downs in the business, while the risk is the probability of making one loss when you sell. As you can see in the 20-year price chart of Nifty, the market improved after each improvement and went on to make brand-new highs. Most investors make a loss because they panic in lively markets and trade. While the book value of your purchase will go down in volatile markets, if you arrange for the market to improve, you will not make a sacrifice. The longer you remain advanced; the more profound is your risk of making a loss.
Mistakes to avoid in a volatile market
Do not panic: Volatility is quite stressful emotionally. No one desires to see investments made with their hard-earned money go downhill. But if you panic and trade, you will gain a tough loss. Being a victim is of utmost significance.
Do not try to time the market: Many investors exchange in bear markets in the promise of buying back at lower prices when the market foundations. It is very difficult to predict the market behind. Look at the business crash in March 2020. When bodies were looking very morose with COVID-19 and approaching lockdown, the market commenced producing in April.
Do not pay to listen to rumors: Rumours start crossing in bear markets. There will be new rumors about looming doom every other day. In this age of social media, you will gain rumors masked as “information”. Do not permit yourself to be beaten by such rumors. It will harm your commercial interests.
Do not try bottom trawling: You may get rewards through informal networks about stocks that are at a bargain-basement valuation and about to give you multi-bagger results. Do not fall pillage to such rumors because this may be similar to grabbing a falling knife. Stick to postulates of diversification through mutual funds.
How to handle volatility in markets?
Goal-based investing: It will help you settle disciplined and not be affected by price changes. For example, if you are funding for your evacuation planning and your goal timeline is 20 years, then slight to medium-term price movements will not affect your objects.
Systematic Investment Plan: Investing within the SIP route for your long term purposes is one of the best strategies that can help you remain disciplined in your long term economic goals. SIP will help you take advantage of volatilization through Rupee Cost Averaging of the procurement cost of properties.
Asset Allocation: Historical price changes of different asset classes like equity, fixed income, and gold show a low or invalidating relationship among these asset properties. Diversification of opposite asset classes can decrease risk and provide confidence across different purchase cycles. Your asset allocation command depends on your financial goals and risk starvation.
Use STP for lump sum investments: Volatile markets stock for tactical investment possibilities in a lump sum. However, if you are concerned about prices helping further, you can always use the STP path from a low volatility fund e.g. liquid fund to spend in equity funds.
Engage with your financial advisor: You require to stay calm and make rational property decisions during volatile warehouses. Seldom is easier said than done. Your financial advisor can be of excellent help to steer you during such times and guarantee your best excitements.
Stick to your investment plan: In any endeavor, having a plan and producing it in a disciplined manner is the best presumption of success in the long term. Finances are no different. There will be difficulties from time to time, but the time-tested chastity of tolerance and discipline will ultimately secure success.
A quick guide to SIP or Systematic Investment Plan