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.

Is the recent stock market volatility unusual?

Before I answer that question, let me try and explain what volatility in the stock market really means. To the ordinary investor, volatility may mean sudden and unexpected changes in a stock’s price (or an index level).

But aren’t fluctuations in stock prices and index levels the norm rather than the exception? That’s an easier question to answer. Yes, stock prices and index levels do fluctuate all the time. But some times, the fluctuations are tolerable and ‘normal’. Those are periods of low volatility, which are conducive for trading and investments.

At other times, there are extraordinary and nerve-wracking fluctuations in stock prices and index levels that send traders and investors scurrying for cover. Such periods of high volatility increases risk and decreases returns.

For the mathematically inclined, volatility is a statistical measure of the uncertainty or risk associated with changes in a stock’s price (or an index level). It can be measured by using the standard deviation or variance (i.e. two standard deviations) of the returns from a stock or index.

A measure of the overall volatility of a stock’s return benchmarked against an index is called ‘Beta’. A Beta value of 1.0 means the stock’s return is the same as that of the index. In other words, if the index gains 100%, the stock will gain 100%. A Beta value of 1.5 means a stock will gain 50% more than the index during bull periods, but lose 50% more during bear periods; a value of 0.8 means the stock will gain 20% less than the index in a bull market, and lose 20% less in a bear market. The higher the Beta value, the more volatile the stock.

For the technically inclined, the Nifty VIX chart indicates the implied volatility (IV) of a basket of Nifty put and call options. A high VIX level (above 30) indicates high volatility; a low VIX value (below 20) indicates low volatility. Typically, when the VIX rises, the Nifty falls. The VIX can be used as a contra-indicator. Low values give an opportunity to sell, and high values provide opportunities to buy.

What causes high volatility? Unexpected changes - in interest rates (repo, reverse repo) or oil prices; a war or terrorist attack or earthquake; a change of government - can lead to wide fluctuations in stock prices and index levels.

What can small investors do? Understand this simple thumb-rule. Volatility declines when stock markets rise, and increases when stock markets fall. In a bear market – like now – high volatility is not unusual.

That is one reason why small investors may be better off staying away instead of trying to make a few bucks on counter-trend rallies; and avoid averaging-down during bear markets.

That was the long answer. The short answer to the question is: No.

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