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Thursday, May 14, 2015

What should small investors do when stock markets turn volatile?

A lay person’s understanding about volatility in the stock market is unusual and large fluctuations in a stock’s price or an index level. But there are more precise definitions of volatility. Here is what investopedia.com has to say: “Volatility is a measure of dispersion around the mean or average return of a security.”

‘Dispersion’ is the size of a range of expected values of a stock price or index level. It measures the uncertainty (i.e. risk) associated with a stock price or index level. The greater the dispersion, the greater is the volatility. ‘Beta’ measures the dispersion of a stock’s or fund’s return relative to a benchmark index. A higher ‘Beta’ means greater risk.

‘Standard deviation’ is a measure of the dispersion of a stock price or index level from its mean. It is, therefore, a measure of historical volatility. Small-cap stocks tend to have higher standard deviations (i.e. they are more volatile and more risky). Large-cap stocks have lower standard deviations – hence they are less volatile and less risky.

Volatility tends to decline during bull phases, and increases during bear phases. What causes volatility? Often, changes in taxes, interest rates and/or inflation can trigger it off. In the current scenario, the retrospective MAT on capital gains by FIIs was the trigger.

Nifty’s Volatility Index (VIX) measures the implied volatility (IV) of a basket of put options and call options on the Nifty. A higher reading on VIX means higher volatility, and is often associated with stock market bottoms. A lower reading on VIX means less volatility – but do not necessarily correspond with a market top.

If you have managed to read this far (without getting thoroughly confused), here are some do’s and dont’s in volatile markets:

  • Don’t sell off in a panic
  • Do stay invested in fundamentally strong stocks
  • Don’t buy 10,000 shares of 3i Infotech just because it has halved in price from 8 to 4
  • Do accumulate large-cap stocks that have corrected more than Nifty

And finally, do invest for the long-term – that means 5 years or 10 years, not 1 year. The longer your investment horizon, the less you will be affected by near-term volatility.

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