Concentrated Vs. Diversified Portfolios: Comparing the Pros and Cons

Most articles on investing advise having a diversified investment portfolio. Diversifying investments is touted as reducing both risk and volatility. 

... One of the advantages of a more concentrated portfolio is that while it does increase risk, it also increases potential reward.

Read more at:

https://www.investopedia.com/articles/investing/030916/concentrated-vs-diversified-portfolios-comparing-pros-and-cons.asp

Nifty chart: a midweek technical update (Feb 13, 2019)

FIIs were net sellers of equity on all three trading days this week. Their total net selling was worth Rs 12.7 Billion. DIIs, who were also net sellers of equity on Mon. and Tue. (Feb 11 and 12), were net buyers today. Their total net buying was worth Rs 3.6 Billion, as per provisional figures.

India's CPI-based retail inflation eased to a 19 months low of 2.05% in Jan '19 from a revised 2.11% in Dec '18, and was much lower than 5.07% in Jan '18. Negative food inflation was the main reason for the low inflation number.

IIP (factory output) showed a 2.4% growth in Dec '18 from 0.3% in Nov '18. IIP was 8.4% in Oct '18. For the Apr-Dec '18 period, IIP growth was 4.6% over Apr-Dec '17.

The following remark was made in last week's technical update on the daily bar chart pattern of Nifty: "A convincing close above 11090 - which is the Fibonacci 61.8% retracement level of the 1756 points correction from the Aug '18 top of 11760 to the Oct '18 low of 10004 - will put bulls firmly in control of Nifty's chart." 

On Wed. Feb 6, the index had closed at 11062.50 - just above the upper Bollinger Band. The next day, it touched an intra-day high of 11118, but formed a 'doji' candlestick by closing at 11069.

Failure to close above 11090 despite two successive attempts, combined with piercing of the upper Bollinger Band followed by a 'doji' formation gave a clear indication that the intermediate rally from the Jan 29 low of 10583.65 was coming to an end.

FIIs, who had led the intermediate rally, turned bears. So did DIIs. Their combined selling has dropped the index below its 20 day SMA (middle band - marked by blue dotted line) and 50 day EMA. Looks like Nifty may be headed below its 200 day EMA towards the lower Bollinger Band.

Daily technical indicators are looking bearish and showing downward momentum. MACD has crossed below its signal line in bullish zone. RSI and Slow stochastic have slipped below their respective 50% levels in neutral zone. Some more downside is likely.

Nifty's TTM P/E has moved down to 26.6, after touching 27.41 on Feb 7 (its highest level in 2019) - but remains much higher than its long-term average in overbought zone. The breadth indicator NSE TRIN (not shown) is oscillating inside oversold zone - hinting at some more near-term downside.

Shares of companies declaring Q3 results below expectations are getting hammered by bears even if they are making profits. A handful of companies whose results have surprised positively have seen their stock prices going through the roof.

The environment is not conducive for small investors to make much money. Mid-cap and small-cap stocks continue to bear the brunt of bear attacks. Even large-caps are tumbling down. Market volatility is unlikely to abate before elections.

With bank fixed deposit rates likely to fall after the RBI rate cut, locking some money into medium term FDs may be a good idea.

The Basics of Bollinger Bands

In the 1980s, John Bollinger, a long-time technician of the markets, developed the technique of using a moving average with two trading bands above and below it. 

Unlike a percentage calculation from a normal moving average, Bollinger Bands simply add and subtract a standard deviation calculation.

Standard deviation is a mathematical formula that measures volatility, showing how the stock price can vary from its true value. By measuring price volatility, Bollinger Bands adjust themselves to market conditions. 

This is what makes them so handy for traders: they can find almost all of the price data needed between the two bands. Read on to find out how this indicator works, and how you can apply it to your trading.

Read more at:
https://www.investopedia.com/articles/technical/102201.asp

Training your Mind in Volatile Markets

Volatility in the stock market can be counter-intuitive. Bull markets aren’t typically filled with huge up days. Instead, rising markets tend to experience a slow and methodical rise higher. 

The best up days are usually seen in the same market environments as the worst down days, which occur during down-trending, volatile markets.

...loss aversion is a big reason why investors tend to make more emotionally-charged decisions when stocks are falling, which causes both panic selling and panic buying during a market downtrend.

Read more at:
https://www.investopedia.com/news/training-your-mind-volatile-markets/

Strategies to Volatility-Proof Your Portfolio

Stock markets worldwide have become quite volatile of late. The first sign of correction has sent many small investors scampering towards the exit door, thinking worse is to follow.

Others have jumped into the market in search of bargains, thinking that markets can't fall much further and the time to buy is now.

Investors who have experienced previous corrective moves and have longer-term views are probably using the market upheaval to rebalance their portfolios. 

A recent article in investopedia.com has suggested strategies for making your portfolio volatility-proof. Read it here.

3 Timeless Investment Principles

In his well known investment book "The Intelligent Investor", Benjamin Graham has explained several investment principles that have withstood the test of time.

If you haven't heard of Graham, he is considered the 'guru' of value investing and was a teacher of Warren Buffett. Graham's book is recommended reading for all small investors.

To appreciate and understand Graham's value investing principles, here are three time-tested ones:

1) Margin of Safety

It means buying a stock  at a price below its intrinsic value. What is intrinsic value? Investopedia.com defines it as the true value of a company's stock based on all aspects of the company's business, including qualitative and quantitative factors. That means putting a value to the company's reputation, business model, competitive advantage, as well as calculating its financial ratios to assess profitability, sustainability, financial prudence.

A DCF (Discounted Cash Flow) method that takes into account a company's free cash flow and weighted average cost of capital is often used to calculate intrinsic value. But even such a calculation is subjective, as it requires certain assumptions to be made about future earnings that may or may not turn out to be accurate.

Is there an easy way to figure out 'Margin of Safety'? One way is to compare the average 'earnings yield' of a company (inverse of the P/E ratio) over a period of 5 to 10 years with the fixed deposit rates of banks. If the average E/P is more than the current FD rate, you have some 'Margin of Safety'. (Otherwise, you may be better off investing in a bank FD.)

Note that higher E/P means lower P/E, which usually happens in bear markets or when a company is not performing well. A company with strong fundamentals in a bull market is likely to have a high P/E ratio and hence low E/P - not leaving much 'Margin of Safety'.

'Margin of Safety' can also be thought of as 'buy low and sell high'.

2) Profit from Volatility

A young investor had once asked John Pierpont Morgan, the famous American financier, banker and art collector, what the stock market will do on that particular day. Morgan had responded: It will fluctuate.

Warren Buffett had said: Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

Volatility is an integral part of stock market movements. Sometimes a market fluctuates so rapidly and wildly that it scares off most investors. But irrational market movements can be your friend, because it allows you to avail of sudden extremes of low or high prices.

If you are a long-term investor and not a day trader, there can be a couple of ways you can benefit from market fluctuations. First is 'Rupee Cost Averaging' (or, SIP), where you invest a fixed amount of money at regular intervals, which smooths out day-to-day fluctuations. Second is investing in a balanced fund, which has a mix of stocks and fixed income instruments; stock price fluctuations are 'balanced' by steady returns of fixed income instruments.

For novice investors, or, for those who don't have the time or inclination for detailed fundamental and technical analysis before buying a stock, regular investment of monthly savings in a good balanced fund is an excellent way to build wealth for the long-term without much effort.

3) Know Thyself

You know yourself better than anyone else. At least, you definitely should. Your investment style and strategy should depend on your personality. Otherwise your market returns will not be up to the mark.

Are you an active and enterprising investor, who loves nothing better than to dig out less-known small-cap or mid-cap companies and then do detailed analysis of their annual reports for selecting future multibaggers? Or, do you prefer to be a passive and defensive investor, who hates bothering about the economy, inflation rate, currency fluctuations, price chart patterns?

Do you enjoy the adrenaline rush of picking an unknown stock based on a friend's recommendation and seeing it rise into the stratosphere, or, would you rather make a detailed financial plan and asset allocation plan and then regularly invest according to your plans to achieve your investment goals?

Only you have answers to such questions. And there are no right or wrong answers. The bottomline is that your personality should match your investment strategy. 

However, remember that wealth can not be built by constant activity of buying and selling. It is built by buying with a 'Margin of Safety', using volatility to book part profits and re-entering at lower levels, and holding on for the long-term to get the benefit of dividends, rights issues, bonus issues and stock splits. 

Read more about the three timeless principles.

Related Post

What exactly is the Margin of Safety?

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.

WTI and Brent Crude Oil charts: an update

WTI Crude chart

The following comment appeared on a previous post on the daily bar chart pattern of WTI Crude oil: “…oil’s price touched a 5 year low of 63 -  and may fall even lower.” After falling below 55, oil’s price has been consolidating sideways in an effort to find a bottom around 55.

All three technical indicators have formed bullish ‘rounding bottom’ patterns inside their respective oversold zones. Does that mean that the strong down trend is about to get reversed?

Strong volumes and sharp volatility in the past few trading sessions indicate investor uncertainty – which often precedes a trend change. However, bears have a strong grip which they are unlikely to release in a hurry. Any upward bounce may be used to sell.

On longer term weekly chart (not shown), oil’s price is trading well below its three weekly EMAs in a long-term bear market. However, the fall since Jul ‘14 has been a bit too sharp. A bounce up is a possibility. Weekly technical indicators are well inside their oversold zones.

Brent Crude chart

The daily bar chart pattern of Brent Crude oil continued its waterfall-like descent and slipped below the 60 level. For the past 4 trading sessions, oil’s price has been consolidating sideways as it tries to find a bottom around 60.

MACD, RSI and Slow stochastic are still inside their respective oversold zones – though all three have formed ‘rounding bottom’ patterns that may lead to an upward bounce in oil’s price. Will it provide a bottom-fishing opportunity? Not really.

On longer term weekly chart (not shown), all three weekly EMAs are falling, and oil’s price is trading below them in a long-term bear market. Technical indicators are well inside their oversold zones.

Stock Index Chart Patterns: S&P 500 and FTSE 100 – Dec 19, ‘14

S&P 500 Index Chart

The daily bar chart pattern of S&P 500 index dropped briefly below 1975, but suddenly turned around and recovered almost all its losses from its Dec 5 top in just three trading sessions. US Fed’s decision not to raise interest rates in the near future provided just the impetus the bulls needed.

All three EMAs are rising and the index is trading above them. The bulls are back in control after a sharp correction. Or, are they? Note that the index is still within the ‘broadening top’ pattern, and needs to overcome the resistance of the upward-sloping blue line of the pattern for the bull market to continue.

An increase in volatility – as witnessed during the formation of the ‘broadening top’ pattern – is a sign of nervousness among investors. Does that mean a change of trend is in the offing? One needs to wait for technical confirmation – but the formation of a bearish reversal pattern should be respected.

Daily technical indicators are back in bullish zones. A continuation of the rally is likely.

On longer term weekly chart (not shown), the index is trading above its three weekly EMAs in a long-term bull market. Weekly technical indicators are in bullish zones.

FTSE 100 Index Chart

The daily bar chart pattern of FTSE 100 dropped to an intra-day low of 6145 on Dec 16 ‘14, but bounced up strongly on the next three days to move above the 6550 level – where it faced resistance from its falling 50 day EMA.

On Oct 16 ‘14, the index had touched an intra-day low of 6073. By touching a slightly higher bottom on Dec 16 ‘14, the index appears to have formed a ‘double bottom’ reversal pattern. However, volumes were higher when the index touched its Oct 16 low.

Also, on a closing basis, the Oct ‘14 low was 6196 whereas the Dec ‘14 low was 6183. That means a bearish pattern of ‘lower tops and lower bottoms’ has been formed.

Technical indicators have corrected oversold conditions, but remain in bearish zones.

On longer term weekly chart (not shown), the index dropped below its 200 week EMA, but managed to close well above it. However, the index is trading below its 20 week and 50 week EMAs. Weekly technical indicators are looking bearish. Bears may mount another attack.

The different mindsets of traders and investors

The terms ‘trader’ and ‘investor’ are often used interchangeably because both participate in stock market transactions. In commodity markets, you will hardly ever hear the term ‘investor’. Why so? Because the mindsets of traders and investors are quite different.

A trader has a ‘short-term’ mentality. Time span for a typical trade can be a few minutes, or hours or at most a few days. An investor has a ‘long-term’ mentality. Time span for an investment can stretch from a few months to a few years.

Traders don’t worry whether the price of a stock (or commodity) is going up or down. If a profitable trade is possible – whether on the long side (up) or short side (down) – the trader will jump in. Investors usually enter long-only positions. They buy at a lower price, and expect to sell at a higher price.

A trader is quick and nimble. If a trade is turning into a loss, such losses are booked quickly by using a strict stop-loss mechanism. If a trade is in profit, the profit is also booked quickly. The process is repeated several times during a day or a week, depending on the traders time frame. An investor is more deliberate and slower in decision taking. Once a stock is bought, it is held for a long time to achieve the profit target. Short-term losses (or profits) are ignored.

Traders thrive when a stock (or commodity) has liquidity (i.e. large volumes) and shows volatility (i.e. big swings in price between the high and low points for the day or week). Liquidity allows trading in large quantities easily. Volatility allows huge profits within a short span of time. Investors prefer steady compounders that rise in price more gradually instead of swinging wildly, and provide returns through dividends and rights/bonus issues.

For traders, price action is the sole criterion. The best way to determine likely price movements in the short-term is to use technical analysis tools - like PSAR, CSI, pivot points. Investors are more concerned about the quality of the company they are planning to invest in. They go through a process called fundamental analysis to assess a company’s near and long-term growth, profit and cash generation capabilities; its management’s competence and integrity; and the valuation of its stock.

Now you know why there are no investors in the commodities market – because there can’t be much fundamental analysis for iron ore or turmeric or guar gum.

What successful traders and investors have in common is a plan and a system that has been developed over time and which has worked for a trader’s or investor’s individual style; and the discipline to stick with a good working system. Most losses are incurred by not having a plan, or deviating from a working system.

The better traders and investors use each others best practices: traders pick and choose the better companies to trade in; investors use some of the technical tools to better time their entry and exit.

Related Posts

Do you like short-term Trading or long-term Investing?

Why stock market, forex and commodity traders use a Pivot Point calculator

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.

Related Post

What is causing the volatility in the Sensex?

Should investors join the ‘Bollinger Bands’ wagon?

Bollinger Bands are a technical analysis tool, developed about 30 years ago by John Bollinger. Before we get into the nitty-gritty of what these bands are and why investors might find them to be a useful tool, a few words about a statistical concept called ‘standard deviation’.

Standard deviation, in layman’s language, means the amount by which a series of measurements vary from the average value of the measurements. Let us say, we are measuring each day’s maximum temperature, and the figures for 5 days are 24, 25, 25, 26, 30. That gives an average value of (24+25+25+26+30)/5 = 26. The absolute variations from the average are –2, –1, –1, 0, 4 respectively for the 5 days. A series of arithmetical manipulations are done on these variation data (squaring, adding, averaging and taking the square root of the average) to arrive at the standard deviation.

Investors need not be math wizards to understand and apply the Bollinger Bands tool - thanks to readily available charting software. But it is always good to know the concept behind the tool. So, what are Bollinger Bands?

It is a technical tool to measure the volatility in prices of a stock or commodity. It consists of a band with three lines. The one in the middle is a 20 period simple moving average (SMA) of the price. The two other lines – one 2 standard deviations above and the other 2 standard deviations below the 20 period SMA – complete the band.

Volatility is measured by standard deviation. As volatility increases, the Bollinger Bands automatically widen. When volatility decreases, the bands contract. Since standard deviation is calculated using a 20 day SMA, a 20 day SMA is also used as the middle line in the daily price charts.

The 20 day SMA with the upper and lower bands 2 standard deviations away is the most commonly used set-up in Bollinger Bands. But other combinations can also be used, depending on price volatility and investment styles. Standard deviation values are higher for stocks (or commodities) trading at higher prices than those trading at lower prices. A higher value of standard deviation doesn’t necessarily mean higher volatility.

Now let us take a look at Bollinger Bands drawn on the 1 year bar chart pattern of Tata Steel:

How do we interpret Bollinger Bands? They do not give ‘buy’ or ‘sell’ indications by themselves, but are used together with other technical indicators to confirm a ‘buy’ or ‘sell’ decision. A contraction of the bands can be used as an early indication of a price rise. Note the contractions in Jun ‘10, Aug ‘10 and Nov ‘10, which were followed by sharp up moves.

If prices keep touching the upper band on a regular basis, it is a sign of ‘overbought’ conditions, usually followed by a correction. Sep ‘10 and Dec ‘10 show such overbought conditions. If prices keep touching the lower band regularly, it is a sign of ‘oversold’ situation, usually followed by a rally. May ‘10 and Jun ‘10 are examples of oversold situation.

Note that the RSI and slow stochastic also confirmed the overbought and oversold conditions on the stock chart. Charts can remain overbought or oversold for long periods. So, selling when the price touches the upper band or buying when price touches the lower band may not be a good idea. A useful strategy when the chart is overbought is to maintain the 20 day SMA (middle line) as a trailing stop-loss. (If you have read my eBook, you will know what a trailing stop-loss is used for. If you haven’t read my eBook yet, why not? It is FREE.)

Some times the price moves above the upper band, or below the lower band. That doesn’t mean that these are sell or buy signals. It gives an indication of relatively higher or lower prices. Note that in Feb ‘11, the stock reached a lower bottom (below the lower band) while the RSI made a higher bottom. This positive divergence gave a ‘buy’ signal.

In Jun ‘10, the stock also reached a lower bottom, but failed to even touch the lower band. This was an early sign of a possible trend reversal. A ‘buy’ signal was generated because the RSI made a higher bottom.

What is causing the volatility in the Sensex?

Of late, the Sensex movements have become very volatile. Some times the index is opening on the plus side and moving higher during the trading day, only to plummet rapidly towards close of trading. On other days, it is opening negative and moving down further, only to regain all its losses by the end of the day.

For small investors, such trading momentum swings can be very confusing. What should one do? What is causing the Sensex volatility, and when will such volatility come to an end? The short answer to the question is: uncertainty. When the causes of uncertainty are removed, and the market is back in a clear trend (whether up or down), the volatility tends to get reduced.

Most investors take short-term views. When they are not sure what is going to happen in the near future, they tend to trade on small spreads. A few paisas of profit, and a sell order goes out. A Rupee of loss, and they try to ‘average’ (which means buying more to reduce the ‘cost’ price). The index becomes volatile as a result.

What are the causes behind the current uncertainty? There are several of them, and these have been mentioned below. Some of them have been building up over the past few months. What was the trigger that suddenly made investors conscious of these uncertainty factors? You don’t need to be an Einstein to figure out the answer. It is the ‘magic’ figure of 20000.

Many investors remember what happened when the Sensex crossed 20000 in 2008. The index crashed by 60%. Will the Sensex behave in a similar fashion in 2010? Some point out that this time it is different. It is the early stage of a bull market with the economy on the upswing. In 2008, it was the tail end of a 5 years long bull market when economic activity had reached a peak.

Others point out that unknown stocks are hitting upper circuits, just like it did in 2008. Also, the huge Coal India IPO may drain out a lot of cash from the secondary market leading to a big fall, just like the Reliance Power IPO did in 2008. (Why any one would want to invest in a notoriously corrupt PSU is another question!)

Despite the best efforts of the RBI, inflation is refusing to come under control. That could mean more interest hikes, which would be negative for the stock markets. The FII inflows continue unabated, even while the DIIs are forced to sell big time due to redemption pressures from mutual funds investors. That is causing the Rupee to appreciate against the Dollar, which in turn, is making exports less competitive pricewise.

When the FIIs started their massive selling in 2008, the Sensex had dropped like a stone. In case they start to sell again, another huge crash may ensue. Because they are not selling, there has been no decent correction in the Sensex in more than a year. So, the continuous FII buying is causing uncertainty, and the FIIs not selling is also causing uncertainty!

Last, but not the least, is the uncertainty of the Q2 results. If the results turn out to be good, the Sensex must have already ‘discounted’ it, so there is not likely to be much upside. If they turn out to be less than expectations, the Sensex may drop.

Note that some of these are short-term uncertainties. The Coal India IPO will be over soon. So will Q2 results announcements. Any interest hike may happen within the next couple of weeks. Why bother about what may or may not happen in the near future? You’ll get to know about it soon enough.

Some say that increased volatility is a warning sign of a trend change. Others say that high volatility is a sign that stocks will rally. If you really believe that the Indian economy is growing, and will continue to grow in the future (even if not at the same rate), then 20000 will just be a milestone along the way. The index is likely to reach much higher levels.

It is the short-term investor sentiments of greed and fear that is causing the uncertainty and worry – and consequently, the index volatility. Take a long-term view – which gurus like Ben Graham and Warren Buffett have advised – and stay invested.

If you want to protect your profits, set stop-losses. When a stop-loss gets hit in an individual stock, sell or book partial profits depending on your risk tolerance and asset allocation plan.

What should investors do when stock markets turn volatile?

The Sensex is undergoing some volatile movements this week - flat on Monday, down 200 points on Tuesday, up 300 the next, down nearly 300 today - going nowhere in particular.

This is a trying time for investors, who are bewildered about what Mr Market is up to. Is this a good time to buy, or sell, or sit on the sidelines?

Patient, long-term investors are probably waiting for a clear trend to emerge. Die-hard traders may be using this opportunity to make some quick trading profits.

To decide what to do, one must understand the cause of stock market volatility. It is usually caused by uncertainty in the minds of market participants. Uncertainty about what? About the near-term market trend.

We had a long bull rally, which made an intermediate top at 17790 on Jan 6 '10. The index had a sharp 10% (1800 points) fall. Since then it is neither going up, nor falling down. Is this the correction before a new rally, or a pause before a bigger fall? Or, is this the beginning of a sideways consolidation movement?

No one really knows. That is the main reason of anxiety among investors, which is causing the volatility. Jeremy Siegel (author of 'Stocks for the Long Run') has observed in his research that stock markets show a tendency to 'revert to mean'.

The current P/E of the Sensex is above 20, and the mean value is closer to 15. Reversion to mean means a bigger fall should be the logical outcome.

High volatility is usually indicative of a change in trend. That again points to a fall, because the previous trend was up. Most analysts and experts have started suggesting different lower levels for the Sensex.

That can be a contrarian play. When every one agrees that the index will fall, Mr Market tends to do just the opposite.

There are no easy answers to the question - except my favourite one. Forget about the index and remain stock specific. Watch your portfolio like a hawk. If you own some less than stellar scrips which are moving up, book profits.

If you own fundamentally strong stocks that are moving down, don't sell in a hurry. If the fundamentals have not changed for the worse, use the dips to add. If you are in doubt, stay out. Wait for a clearer trend to emerge.