It is important for investor to understand the concept of volatility and learn how to mitigate the impact of same
It is in the very nature of capital markets to be volatile. Different investors have different risk profiles, distinct time horizons and varying return requirements. This means that for every buyer there will almost always be a seller. This also means that stock prices will always be in a constant state of flux. It is due to this volatility that stocks are considered as “risk assets.”
However, it is important for an investor to understand the concept of volatility and learn how to mitigate the impact of the same on his or her portfolio.
Market volatility is basically the range of uncertainty associated with the rate of change in investment value and the variation in its price, in a specific time period. Interestingly, volatility is neutral to the direction of the movement indicating that it captures both, upward and downward asset price movements.
Assets with a high volatility are generally considered high risk as there is more uncertainty regarding the future outcome of such an investment. On the other hand, an investment with low volatility would experience minimal price fluctuations during a specific period. Due to minimal variation in prices, these investments are generally considered low risk.
Volatility can be viewed as a risk, as well as, an opportunity. Sharp and uncertain movements in the price of a stock can influence investor behaviour and impact his or her ability to make rational investment decisions. Periods of high volatility are generally associated with falling markets while stable growth markets are associated with low volatility.
It has been observed that in volatile market conditions investors often panic and exit their investments in an attempt to avoid risk. However, the same investors end up re-entering the markets closer to peaks when the markets are trending and are therefore, less volatile. Consequently, they end up making sub-optimal investment decisions. On the other hand, volatility can be a boon for the patient value investor who is looking to buy stocks at compelling valuations.
I am sure that nearly every investment advisor will tell you that one of the best ways to mitigate portfolio volatility is to stay invested for the long-term. This indeed is true. Long-term investing can not only smoothen the impact of the ebbs and flows of the markets but also keep investors disciplined and keep them from making irrational decisions.
Another way to mitigate the risk associated with volatility is to diversify your portfolio and invest in a mix of assets that have a low correlation with each other. This will ensure that the higher volatility of one asset class is neutralised by the lower volatility in another asset class.