History has shown that there will always be periods of market volatility with sharp fluctuations in both directions. Although these fluctuations are a normal occurrence, they can still be stressful for investors, causing a negative impact on their portfolio and leading to doubts about their financial strategy. Having an understanding of market volatility and its potential causes can help you better handle the emotions that come with it. This article highlights the causes of market volatility and how investors can benefit from it by focusing on strategies that take advantage of it instead of being concerned about it.
What causes market volatility?
Volatile market conditions can arise abruptly and without prior warning, but they are typically caused by specific events, including:
Unexpected economic news that deviates from investor expectations, such as an unexpectedly high Consumer Price Index.
Sudden shifts in monetary policy, such as change in the repo rate by Reserve Bank of India.
Political happenings, including surprising election results, government shutdowns or events such as demonetization, budget announcement, etc.
Geopolitical incidents, such as military conflicts or increasing tensions or war-like situations between nations, that can have economic repercussions.
Market-specific events, such as the overvaluation of stocks, which was the case with the "dot-com" stocks in 2000, when a sudden selloff occurred as investors became concerned that prices had become detached from company fundamentals.
How to deal with market volatility?
During periods of market turbulence, when stock prices are falling, the constant barrage of negative news can create a sense of hopelessness. This can lead to increased stress, doubt, and impulsive choices, even among experienced investors. However, it's essential to maintain a level-headed approach during these times. Here are six approaches to adopt during periods of market volatility:
1. Reassess or update your financial plan:
Having a financial plan in place provides some level of security. It is essential to evaluate your financial objectives and the timeline for achieving them when reviewing or creating your plan. If they are no longer feasible, make modifications to ensure you stay on track to reach your priority goals. You must examine your monthly budget to ensure it is feasible and covers essential expenses. If needed, find ways to cut spending in order to allow you to put additional funds towards your most crucial financial goals.
2. Reassessing your risk tolerance:
In volatile market conditions, it's crucial to be proactive rather than passive with your investments. Your financial future and money are at stake, so understanding your risk tolerance level is important for achieving comfort with both your financial plan and portfolio.
When considering your risk tolerance, it's helpful to ask yourself the following questions:
Can you handle moderate losses in your investments over time and exhibit patience to recover from setbacks? If yes, you may be able to take a moderate to high level of risk with respect to your investments.
Do you get anxious about your portfolio during market downturns? If so, you may want to reduce the risk in your portfolio.
How close are you to retirement? If you are within five years of retiring, you may want to reduce risk in your portfolio to avoid significant losses before or during retirement. On the other hand, if you have 20 or more years before retirement, you have more time to potentially earn higher returns by taking on more risk and weathering market challenges.
Thus, assessing your risk tolerance level helps you to chalk out a well-defined asset allocation strategy for achieving your financial goals. Asset allocation helps you to diversify your investments across multiple asset classes like equity, debt, gold, etc. However, it is necessary to remember that no single asset class is guaranteed to perform consistently every single year. For example, after strong returns in the years 2020 and 2021, equities had a slowdown in year 2022, while gold, which had negative returns in year 2021, generated positive returns in the year 2022. As it is impossible to predict which asset class will perform well and when, it is wise to have a diversified portfolio that covers multiple asset classes based on your financial goals.
3. Diversification:
As discussed above, having a well-diversified portfolio can withstand market volatility and this starts with owning an investment mix that suits your level of risk tolerance. The assets you hold should be spread across three main categories: equity, debt and cash. To further diversify, you may want to consider various types of investments within each category. For example, in stocks, you could include a mix of small, medium, and large-cap stocks, along with international stocks, growth and value stocks and various industry sectors. Debt instruments like debt funds, fixed deposits, government bonds, corporate bonds and bonds of different maturities can be your go -to option when seeking fixed income or capital protection. However, debt is an often misunderstood and underappreciated asset class in the investing community, despite its crucial role in providing stability and protecting against market downturns. When interest rates are projected to rise in the near future, it's crucial not to dismiss debt simply because it doesn't produce high returns like equities. You can consider short-term debt schemes and take advantage of high interest rates through various debt investment options.
Within mutual funds, categories like balanced advantage or dynamically managed asset allocation, provide a structured approach to benefit from market fluctuations. These schemes typically have a counter-cyclical strategy and offer exposure to both equity and debt. Additionally, you can consider having a small portion of their investment (may be 10 percent of the total investment portfolio) in gold particularly Gold Exchange Traded Funds (ETFs). It's essential to review your portfolio at least annually and make any necessary adjustments, such as rebalancing your portfolio if your asset allocations change due to investment performance and stay aligned with your goals.
4. Avoid fidgeting with your SIP:
Temporary losses can cause stress but allowing emotions to guide investment decisions can be costly.
Dealing with market volatility requires focusing on long-term outcomes instead of short-term fluctuations. Maintaining a steady approach can be challenging, but it also presents opportunities.
For long-term objectives, such as funding a child's education or purchasing a home, equity is a suitable asset class due to its potential for growth and capital appreciation. In fact, investing for long-term wealth creation or financial goals without exposure to equities is almost impossible because equity is the only asset class that can provide returns that keep pace with inflation over the long term. However, the unpredictable and volatile nature of the equity market can be unsettling, as it is impacted by various domestic and global factors discussed above. This can change market sentiment and make it impossible for an investor to predict the direction of the equity market in the short to medium term.
Some investors who invest in mutual funds via Systematic Investment Plans (SIPs) to create wealth, during periods of market volatility, may pause or stop their SIP as a way to protect their capital. The thought is that they'll restart the SIP once the volatile or corrective phase is over. However, what makes a SIP so effective in creating wealth is the larger number of units accumulated during downtimes or stagnant market phases, which become more valuable as the market rises. So, don't make the mistake of pausing or reducing your SIP simply because market conditions appear unfavorable.
5. Have an emergency fund:
Emergency cash savings provide a safety net for unforeseen expenses or tough times. It is generally recommended to have 3-6 months of income readily accessible for immediate needs. However, if your income is more variable during economic difficulties or due to the nature of your job, consider increasing that to 6-9 months or more to provide greater financial stability during tough periods.
6. Consult a financial advisor:
In the face of rapidly changing economic conditions, a financial advisor can help you evaluate your situation and make necessary modifications to your financial plan, whether it's to safeguard your finances or seize new market opportunities. This can give you peace of mind and help you achieve your financial goals.
Conclusion
One can expect volatility to occur from time to time, but it is important to keep in mind that these fluctuations are usually temporary in nature. Disciplined long-term investing is crucial in equity investments to mitigate the impact of short-term fluctuations in returns. Behavioral biases, such as fear of loss, following the crowd, etc., may lead to poor investment decisions. In fact, market downturns can offer investors the opportunity to purchase quality investments that have temporarily decreased in value at a lower price. Historical data also indicates that the long-term trend in India's growth market has been positive, leading to substantial wealth creation for patient investors.
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