Investing in Equity Volatility is your ally

A common mistake investors make, which is detrimental to their financial well being, is conflating the terms volatility and risk. The fall out of this confusion is that volatility scares investors and they shirk equity. Granted, the term risk has different meanings for different people. Ask an investor what comes to mind when talking about risk, he will state that he does not wish to lose his money, or will want to know as to how much the return can potentially drop by. Throw the same query to a finance professional and he will probably say that standard deviation is the measure of risk. But while professionals may employ volatility as a proxy for risk, it does not measure what an investor intuitively perceives as risk.

In his annual letter to shareholders of Berkshire Hathaway in 2014, Warren Buffett wrote about the difference between the two. He noted that stock prices will always be far more volatile than cash-equivalent holdings. But, over the long term, the latter are far riskier since you face the possibility of not having saved enough after taxes and inflation have done their bit to erode the value of that investment. That very year, Howard Marks wrote a note to his clients on the same subject.

His very words: "I don't think most investors fear volatility. In fact, I've never heard anyone say, 'The prospective return isn't high enough to warrant bearing all that volatility.'

What they fear is the possibility of permanent loss." So how do you avoid permanent loss? By making sure that you invest in quality stocks or funds. Even when you do so, would your investment go through tumultuous times? Most certainly. Does that mean you have to exit when it gets volatile? Absolutely not. In 2008, we all know how volatile the market was. The Sensex dropped to a low of 7,697 in October that year (after touching a high of 21,206 earlier in 2008 - so you can imagine the volatility). Yesterday, it closed at over 30,000 (in less than a decade). During this period, the market had tremendous bouts of volatility: Global Financial Crisis (2008), Dubai Debt Crisis (2009), European Sovereign Debt Crisis (2010), Global stock markets crash (2011), China's Black Monday (2015), and Brexit (2016). Nevertheless, investors who stayed focused on their investments have certainly reaped the benefits. Volatility is not a proxy for risk. This pedagogic assumption is wrong. And if you equate the two or view them as synonymous, you could commit some grievous errors in your portfolio. Here's how to create a mental distinction between the two and benefit from it.

Volatility is inevitable.

Come to terms with it. Do not avoid equity (stocks or funds) because it is an inherently volatile asset class. It is normal for stock markets to react to the economic, political and corporate environment. It is helpful to think of volatility as sudden price movements. Volatility encompasses the changes in the price of a security, a portfolio, or a market segment both on the upside and down. So it's possible to have an investment with a lot of volatility that is moving one way: up or down. Even more important, volatility refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period—a day, a few weeks, a month, a few months, and maybe even a year. Such fluctuations are inevitable and come with the territory. If you are in for the long haul, volatility is not a problem and can even be your friend, enabling you to buy more of a security when it's at a low ebb. Which brings us to the next point.

Volatility can be your ally.

Investors have no problem with volatility when the price is moving upwards. However, they panic when it is the reverse.

Seth Klarman has an interesting take on this. According to him, risk is not inherent in an investment; it is always relative to the price paid. So when great uncertainty and volatility - such as in the fall of 2008 - drives stock prices to especially low levels, they are excellent buys and often become less risky investments. Instead, investors prefer to buy on the way up when it is much riskier since they are paying a high price for their investment. Harness volatility for your benefit, buy when the market is headed downhill. When buying stocks, have an idea of its intrinsic value. If the market undershoots, the volatility drives opportunity. Corrections are a normal part of bull markets and can often be a good time to invest in equities as valuations become more attractive, giving investors the potential to generate above-average returns when the market rebounds. Volatility is not the problem, you are. When stock prices are on the way down (which will also affect your equity funds), don't panic and exit. This is one reason we advocate investing in an equity mutual fund via a systematic investment plan, or SIP. This does away with the emotion that comes along with investing. It also ensures that you are entering the stock market in a variety of environments, whether its feels good or not.

Diversification has a role.

Diversifying your portfolio among different asset classes and investment styles can also go a long way toward muting the volatility of an investment that's volatile on a stand-alone basis. Over the long term, equity is profitable. An economic daily last year carried a post which cited stocks that have posted returns of over 10,000% over the past decade. Some examples were Symphony, which was around Rs 14 levels in December 2006 and is now at Rs 1,400 levels. Ajanta Pharma is another at Rs 1,600 levels, up from Rs 70 levels a decade ago. Of course there were also stocks that eroded shareholders' value (and the article did mention a few). However, the point being made is that investors in these stocks would have benefited if they stayed on during the market upheavals over the decade (which were mentioned earlier). Ditto with funds. If we look at the average 10-year annualized return of the various fund categories, investors who stayed on despite the down markets of 2008 or 2011 would have been well rewarded: Large-cap (10.40%), Flexi Cap (12.50%) and Small/Mid Cap (15.27%). The funds did not have a smooth ride. The Small/Mid Cap category fell by (-)58.75% in 2008 and (-)25.67% in 2011. In 2013, the category average was a meager 2.31%. But an annualized return of 15.27% over this decade speaks volumes concerning the return on equity over and above the inevitable volatility. Sentiment and news will induce volatility. If you have invested in quality funds and stocks, stay focused.

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