life in financial markets: (part 2 of 2) why be afraid of volatility?

Last Monday, I blogged about volatility in equity markets. This post is a continuation of that.

Volatility, inevitable though it is in the context of equity markets, need not be dreaded. The best way to to deal with it is to follow set principles of investing that do not change no matter how much the stock prices change.Wise financial planners would not even want to track the index movements on a day to day basis.

Its a test match and not 20-20! Stockbrokers will mock you saying "in the long run we are all dead" but equities fetch certain returns, higher than fixed income assets, over a long time span of 10 years and more. But you need to stay committed to your equity investments continuously over this long time and not get carried away with bouts of panic selling during crises and excessive buying during irrational exuberance in the markets.

Have a big heart! Build a diversified portfolio of equities comprising of several stocks and a couple of exchange traded funds (ETFs). If you prefer mutual funds then ignore direct stocks and have a portfolio of several equity schemes of mutual funds, but do also hold some ETFs. Think of earning decent returns on a portfolio and not on select stocks. If the Sensex is crashing it does not necessarily mean that the value of your portfolio is crashing as well.

The stocks or ETFs you hold, when taken as an aggregate, may or may not co-relate very closely with that of the Sensex or Nifty. If it does then it is pointless to have this portfolio and you should instead just put all your money in a Nifty ETF and sit quite. Inversely, when Sensex is at its peak do not get tempted to book profits because your portfolio returns may not have risen as much as the Sensex.

Slow and steady wins the race! Buy little but buy at least once every month. Scatter your purchases across a minimum of 12 periods in a year with more or less equal amounts of investment each time. This will average out your cost of purchases over a longer time frame and any bouts of high volatility like the one seen from mid-October to mid-November will not affect your investments adversely.

If you are buying into stocks through your broker then do so at different time slots during a trading day. Avoid the first and the last one hour of the day as markets generally are trying to find their rhythm in the beginning and traders are generally trying to rush to close their open positions during the end of the day.

Re-jig to cut the flab! Equities should ideally be one of a few asset classes in your overall investments. If you have set a 60:30:10 ratio for investing in equities, debt and gold for a specific period then ensure that during that period this ratio does not get skewed towards any particular asset class. "Re-balance your portfolio not because markets have risen or fallen but because the value of your investments in a particular asset class has gone above or below the initial limit you decided upon," says Mashruwala. He suggests this be done once every quarter.

Re-balancing should be done through selling that much part of the asset class that has gone above the limit and using the proceeds from this to buy into the asset class that had gone below the limit. As your age progresses you may want to re-set the asset allocation ratio itself. Say, you change it to 40:50:10 for equities, debt and gold. This too involves re-balancing.

Long, but not teary, farewells! When to sell and how much t sell are the two most difficult questions in investing. It is time to sell when you are re-balancing or when your pre-determined investment tenure is over. When you sell to re-balance you should sell a little part of many component of your equity portfolio. You should not sell all your holdings in one, or few, stocks or an ETF in one go.

Even on completion of your investment tenure you should not sell whole of your equity portfolio in one go. Just as you bought little every month during the investment tenure you should sell a little every month after the tenure is over. This averages your cost of selling.

The above strategies are good enough.If you want some adventure then you can also directly exploit, an expectation of high volatility, in the equity derivatives segment. One of the most common ways to potentially profit from expected volatility is through a 'straddle' that involves buy a call option and a put option of the same strike price. On 10 November, spot Nifty closed at 4880. The premium on a November-end put option on Nifty of strike price 4900 traded at Rs 125 during the close, and that of call option on Nifty of same strike price traded at Rs 100. If you bought both these options and paid an aggregate premium of Rs 225 then you will profit from a rise or fall of Nifty of 225 points from its level on that day till the end of November. If it doesn't then your loss will range between Rs 100 and Rs 225.

Volatility can not be wished away. Dealing with it patiently helps.

life in financial markets: (part 1 of 2) why be afraid of volatility?

(this is part 1 of the subject matter of this post... part 2 will follow after a few days...)

I can not but feel amused when people, who are supposed to know better, get excited about volatility in the stock markets and then go on to call them all sorts of names like "mad" and "manic".

Volatility is an intrinsic part of the markets that predominantly affects, both positively and otherwise, day traders and short-term speculators. But it does not, I repeat, does not matter to long-term investors how markets are moving from one day to another. When you are investing a little, once or twice a month, on randomly-selected days, you can never be hurt badly by volatility.

So, what exactly is volatility? One out of a couple of dictionary meanings of 'volatile' is something that is difficult to capture or hold permanently.

The commonly accepted technical measure of volatility for a stock—and an index (which is a combination of stocks)—is the standard deviation (SD) of day-to-day price changes for a period. SD is the square root of the variance and variance, in case of stocks or indices, is the average of the squared deviations of the daily changes during a period from their average. An accepted-and-followed mathematical theorem then says that at least 75 per cent of the values will fall within plus and minus two standard deviations from the mean of a distribution.

Take, for example, 10 day-to-day changes in Nifty during 11 trading days. Find its simple average. Say, it is -0.3%. Calculate, for each day-to-day change, its deviation from the mean. Square each of these 10 deviations. Then, total these 10 squared figures and divide by 10 to get their average. This is the variance. Its square root is the SD.

Say, the SD is 1.6%. Now, applying the theorem it follows that would be at least 7-8 days (75%) on which the daily Nifty change would be between -3.5% [-0.3 - (2*1.6)] and 2.9% [-0.3 + (2*1.6)]. If the SD (volatility) for the next set of 10 days is higher than 1.6% then it follows that this range has widened.

Another measure of volatility in the financial markets is the movement of a Volatility Index (VIX) that takes the implied volatility from actively traded index options trades. The most tracked VIX is that of the Chicago Board of Options Exchange. In India, the National Stock Exchange too has its own VIX based on Nifty options trades.

It is generally believed that when VIX goes above 30 the stock market is likely to experience a correction. See below (click on the image to see it enlarged & clear) to the see the co-relation between S&P 500 (US) and CBOE's VIX, as well as between S&P CNX Nifty (India) and NSE's VIX.




Global equity markets tend to co-relate in the short term but it is interesting to note how their narrow differences widen over time. Below is a graph I made of global indices movements from end of 2005 onwards (click on the image to see it enlarged & clear).