‘As volatile as the stock market’ is a widely used expression in the English language. This expression was forgotten as volatility took a backseat in 2017 as market powered ahead on expectations of an earnings rebound, lower interest rates and abundant liquidity unleashed by demonetization.

While 2017 was a unique year that gave positive returns across asset classes, Indian Stock Market in 2018 has been on a roller coaster ride marked by sharp climbs and quick drops.

The volatility is mainly driven by unfolding concern about trade wars, increased protectionism, widening Current Account Deficit as well as sharp rise in bond yields.

Watching these events unfold with its “sky is falling” backdrop may make the savviest investor experience the stomach-churning sensation.

These situations also make an investor wonder whether the investment is on the right track? Will it be beneficial to liquidate certain holdings and park it into safe assets and invest it back after the correction? While there is an inherent itch to do “something”, making reactive decisions based on short term volatility will be more detrimental to portfolio performance than the broader market decline.

Understanding Investor Behavior

There is a popular quote that describes human behavior: “we are our worst enemies”. While this quote was intended to describe human behavior, it explains investor behavior aptly. Investors, in general, know what they should do. However, it is during period of profound volatility and downturns, that they react in a sub-optimal manner. The reason being decisions are being driven by emotional responses like fear or jubilation. Investors often panic about sustaining losses, and will alter long term strategy as a result. Altering strategy is a natural defense to the feeling of needing to “do something to prevent losses” i.e. making knee jerk reactions.

Here’s an example: You’re evaluating your Investment Policy Statement (IPS) and looking at risk tolerance. Various factors indicate that ability and willingness to take risk is high. You agree to it and select a portfolio that offers potential gain of 14% as well as loss of the equivalent amount. After 4 months, you check your investment and identify that while things were going smooth, a recent downturn has caused you to lose 7% of your investment. Panic sets in. Do you sell, buy or do nothing?

This is a classic dilemma that every investor faces wherein the option is to bite the bullet or stay put and do nothing. Studies suggest that investor who resisted trying to time the market and simply stayed invested – through bad and good times outperformed investor who stayed away for whatsoever reason. While the principle may look simple on paper, implementing it requires restraint and discipline. As Warren Buffett points out, “Investing is simple, but not easy”. The reason being when it comes to investing, we become extra sensitive as the pain of loss far outweighs the pleasure we get from gain of an equivalent amount.

Managing Volatility

To quote former President Franklin Roosevelt, “the only thing we have to fear is fear itself”. Volatility (a.k.a. fear index) may indicate trouble but what is important is to understand that volatility in itself is not risk; it is noise. An interim trouble that an investor must withstand and absorb to achieve its objective. To manage volatility, an investor should:

• Diversify amongst uncorrelated asset class. During volatile times, while some will lose value, there will be simultaneous gains elsewhere. In the end, you win some. You lose some.
• Take a long term approach and evaluate if this downturn is actually going to impact your goals. For example, goal is to buy house after another 10 years. Will a temporary decline impact the goal?
• Use dollar cost averaging which basically involves investing fixed amount at a particular date. The frequency can be weekly, monthly, quarterly or annually. The rationale being it brings in discipline as well as help take the emotions and the instincts out of investing in volatile markets.
• Don’t check that portfolio value every single day. Consider the fact that value of our home also changes on a regular basis but we don’t experience the same anxiety as we do with stock. The reason being we do not derive value of our home at the click of a button. Just because portfolio value is readily available, doesn’t mean we track it constantly.

Staying the Course

Experiencing volatility is a part and parcel of being an investor but quite often it is just temporary event that causes an investor to deviate – when the best course is to stay put.

There is a popular Wall Street adage: “You can eat well or sleep well”. Investing in a diversified portfolio and staying the course, over the long run you will eat well but then there always be sleepless nights when markets are volatile.