scorecardresearchDiversification in investing: Here's how to reduce risks during volatile markets

Diversification in investing: Here's how to reduce risks during volatile markets

Updated: 09 Jan 2023, 11:54 AM IST
TL;DR.
The higher the frequency and magnitude of stock price movement, the higher is the volatility and consequently risk associated with buying the stock. Below are some of the common mistakes investors make in volatile markets
How diversified portfolios can help reduce risks during volatile markets

How diversified portfolios can help reduce risks during volatile markets

Prices of most stocks never stay still. They keep changing every minute and either gain or lose value every trading day. During times of crisis, like the announcement of covid lockdown, the frequency and magnitude of price movement became very high. This frequency and magnitude of price change indicates volatility and is a measure of risk. The higher the frequency and magnitude of stock price movement, the higher is the volatility and consequently risk associated with buying the stock.

Markets across the world, and India in particular, have been volatile in recent times. After continuously trending up since April ’20, markets were flat between Oct 21 - Jan ‘22. Increasing tensions between Russia and Ukraine started affecting oil prices. As oil prices started rising, inflation started trending up. This affected stock markets and Nifty started trending down. As the Russian invasion of Ukraine began in Feb ‘22, oil prices and consequently inflation continued to stay high.

In April ‘22, inflation hit an eight-year high of 7.79% corresponding with a drastic fall in the markets. Between Jan ‘22 and mid - June ‘22, Nifty dropped ~12%. The war affected supply chains across the world, pushed up prices of commodities like wheat and oil and this resulted in persistently high inflation across the world.

To combat this, RBI has been increasing repo rates since April ‘22. The Central Bank has so far raised repo rates by 190 bps (1 bps is 0.01%) to 5.9%. RBI is still expected to deliver a 35 to 50 bps rate hike to manage inflation within the mandated band of 2-6%. As a consequence of these factors, global growth has been trending down.

The International Monetary Fund predicts global growth will slow to 2.7% in 2023, 0.2% points lower than its July forecast. India is expected to grow at 6.8% in 2023, significantly below the 8.7% recorded in 2022. The 2023 growth rate for India has been revised downward by 0.6% points relative to the IMF’s June 2022 forecast. Inflation is also expected to continue to remain high in the near term. All these factors are expected to affect stock markets, causing volatility in the near to medium term.

Below are some of the common mistakes investors make in volatile markets :

Panic selling: When markets dive, investors often make the mistake of exiting equities at a low. This is because investors are generally loss averse. They tend to prefer avoiding losses to acquiring equivalent gains. They fail to understand that emotions only drive the stock market over shorter frames. Fundamentals always drive the stock market over long periods. The best thing to do is to stay invested as long as the investment rationale does not change.

Attempting to time the market: Once investors panic sell at a low, they compound the mistake by trying to time the market and buy in when market conditions start improving. This results in selling low and buying high.

Staying in cash: We all love those big sales and our favourite brands selling at discounted prices, except when it happens in the stock market. Investors fear short-term volatility and avoid investing money they otherwise would have invested..

Consequences of these mistakes can be grave, especially for novice investors. It is common knowledge that the long-term activity of investors in the stock market is directly correlated with the success of their first investment. If the investor suffers a loss during their initial days of equity investments, he/she gets disheartened. Not attempting to understand the reason for the loss/underperformance and the risk associated with equity investing, the investor quits investing in equity instruments.

For example, a recent phenomenon is investing in equities after watching influencer videos. Investors confuse discussions around high volatile stocks as recommendations, without understanding the associated risk, buy the same. They are then disheartened when the stock’s price drops.

The simplest way to reduce or avoid high risk associated with investing in single stocks or a group of 1-2 stocks is to take a diversified portfolio investing approach. It involves combining a wide range of instruments and investment styles to reduce portfolio risk. The instruments commonly used are equities, bonds, commodities like gold and even real estate. 

Investment style involves selecting different sub-asset classes within an asset class to mitigate portfolio volatility. For example, investing in growth stocks as well as value stocks, buying into large-cap companies as well as mid-cap companies, etc.

One method of building such a portfolio is by following the core - satellite approach. This approach involves breaking down the portfolio building process into 2 parts :

The core part

Preferably, the core portfolio should provide exposure to diverse asset classes like equity, gold, debt etc.

The core portfolio should only include passively managed assets. This ensures that the core generates returns in line with broad market returns. Additional advantages of passively managed assets are low expense ratio, low transaction cost and tax efficiency.

Investors can build a strong core by using ETFs and REITs. ETFs like Nifty Bees and Gold Bees provide exposure to large-cap equities and gold respectively. Bharat Bond ETFs provide exposure to debt. Real Estate Investment Trusts (REITs) are companies that own and operate income-generating real estate. India currently has 3 listed REITs.

A smartly built core provides stable long-term returns and ensures that the foundation of your portfolio is strong, protected and growing.

The satellite part

In the satellite part, investors should take exposure to actively managed funds or directly invest in a group of stocks. The goal is to select investments that can outperform the broader market, either via market timing or stock selection. This aspect of the portfolio will incur higher transaction costs due to higher portfolio churn. The majority of fund managers cannot beat the index consistently. So investors will have to periodically study the funds/managers' performance and change them if necessary.

The core - satellite is a common sense portfolio-building approach that provides access to the best of both active and passive investment. While the core fund has lower cost and limited volatility, the satellite offers the potential for outperformance.

Just like old age, market volatility is also a fact of life. While one cannot wish it away, following common sense investment approaches and avoiding basic investment mistakes will ensure that investors will beat the market over the long run.

Naveen Kaushik Ranjan, smallcase manager & AVP, investment products, Windmill Capital
 

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First Published: 09 Jan 2023, 11:54 AM IST