8th November, 2021
Capital markets are based on volatility in the market. No one can make a profit if there is no price movement in the financial markets.
However, frequent or extreme volatility in the market is unwanted and can be mitigated to lower levels. Certain righteous measures in investing can reduce the volatility in your portfolio to much lower levels.
Here are the points that Investors need to take note of to avoid pitfalls of volatility in the financial markets.
1. Research the Market
Signs of a tumbling market can be perceived through research and analysis of the concerned market.
According to Trade Forex Nigeria, “You need to know the factors affecting the instruments you are trading or investing in. Like Commodities are affected by Global Demand and Supply, geopolitics, weather, natural disasters, transportation and Currency pressures etc.”
In 2020, global commodities and currencies were impacted by the pandemic which hit global demand, supply and trade.
Crude Oil prices were also impacted by the Geopolitical price war between gulf countries and Russia. This had a cascading effect on global Commodities, Stocks and Currencies.
Emerging markets and Oil producing nation currencies were impacted the worst and most affected were Brazilian Lira, Russian Ruble, Mexican Peso, Turkish Lira, South African Rand, Canadian Dollar, Norwegian krone and Nigerian Naira.
This also impacted economies, companies, stock markets in the affected countries. Due to which many investors lost billions.
Proper research of the market where you are investing your money can greatly assist in reducing volatility.
If a volatile trend is expected in near future, investors can prepare themselves by putting stop loss and can take advantage of the volatility.
Volatility indices like VIX can help predict upcoming volatility in the stock market.
Higher VIX than average depicts increased volatility in the near future or a change in price trends.
Analysis of the stock price volatility index can also assist in predicting volatile trends in other capital markets.
2. Make a Financial Plan and Don’t Abandon it
Investment should always be done according to a plan. The plan must have a defined objective and the investment strategy should be based on the objective.
It can be retirement planning, buying a car/house, children’s education, etc.
Sudden fluctuations in the market must not interfere with the objective of the financial plan.
A change in the plan due to sudden volatility in the market based on emotions is malpractice.
Nigerian investors may refurbish the strategy or portfolio if there is no desired output in a prolonged tenure. Although, investors should never abandon the financial plan due to market fluctuations in short term.
3. Invest Consistently and Don’t Stop your SIP
A Systematic Investment Plan is a periodic method of investment.
This allows the investor to take the advantage of compounding along with cost averaging.
Each investment is done at different prices and the average of all the prices is the investment cost. SIP provides long-term benefits and reduces the effect of volatility on the portfolio.
Some Investment apps like Cowrywise offer SIP for investment plans.
The major malpractice among less experienced investors is to skip the SIP when the markets are volatile.
More units can be bought when the prices are low and by missing this opportunity to invest, the portfolio will be negatively affected.
One must never skip the SIP instalment. Consistency in investments can help you achieve financial goals in long term.
4. Never Make Impulsive Decisions
Investment decisions based on emotions and impulses can never help in achieving financial targets.
Instead, such actions have higher chances to lead to severe losses. Emotion-based investment decisions are generally based on sudden price movements in the market.
Quick gains or losses can also lead the investor to take bad decisions driven by fear, greed, and other emotions.
Investment decisions should be based on research and objective. The fundamentals and technicalities must be analysed before making any investment decisions.
Investors must check all possible outcomes and long-term prospects of the investment decision.
Advice from experts can be considered but research and analysis must be done before making an investment. Unsolicited advisory from knowns and relatives must be avoided.
5. Diversification can Reduce risk of Volatility
It can be mathematically proven that diversification in the portfolio reduces the beta or volatility in the portfolio.
In the investment world, you must never put all your eggs in one basket.
A well-diversified portfolio contains instruments from multiple capital markets.
Multiple subcategories of instruments can be picked from any particular capital market. You can create a mix of portfolios comprising of high return and low-risk instruments.
For e.g., stocks from different sectors and sizes can be picked in a stock portfolio to create diversification.
You can have growth stocks and value stocks in your portfolio which will have high future returns with growth stocks and stability, consistent returns with value stocks.
Also, investors can diversify through investing in Indices & ETFs which have mix of stocks from various industries or same sector.
You can also invest in multiple asset classes like Commodities, Currencies, Metals, Bonds etc.
With derivatives like Futures & Options, you can also hedge your investment risk or speculate against market trend by going short or long.
If you are a forex trader or simply want to speculate on different instruments in the global markets, then you can trade i.e., short or long a range of global currencies and other instruments through regulated forex brokers that are licensed with Tier-1 & Tier-2 regulators like FCA, FSCA & ASIC.
With these brokers you can trade CFD Instruments to speculate on various forex pairs, commodities, global equities and Indices.
All instruments of a particular category are likely to behave the same in similar trends.
Choosing different types of instruments from different asset classes will reduce the negative impact of any particular instrument.
This will eventually reduce overall volatility in the portfolio.
The returns will become constant as the risk is spread across multiple instruments. Over-diversification in the portfolio (investing in too many instruments) may lead to restricted gains.
6. Active Risk Management Approach
Each investment portfolio can be compared with the benchmark that has all the selected instruments.
The actively managed portfolio is aimed to beat the returns of the passive benchmark portfolio. By attempting to beat the benchmark, the investor takes a certain extra risk that is called active risk.
The extra risk taken must provide extra returns over a passively managed benchmark portfolio.
If the portfolio is not providing better returns than the benchmark, changes can be made in the portfolio. Investors can also copy the passive benchmark portfolio.
Other risk management strategies like Diversification & Asset Allocation, measuring Risk to Reward ratio, setting max risk tolerance using stop loss must also be followed.
7. Risk to Reward
The risk to reward ratio describes the risk taken for probable gains in investment. It is a ratio that shows the expected unit gains for a dollar at unit risk.
Investors should seek for instruments that have higher return generating ability at the expense of the lowest risk.
The risk to reward ratio must be checked and compared before choosing any of the financial markets for investment.
Investors in Nigeria should seek the instruments and asset classes that have a risk to reward ratio of more than 1. i.e. For each unit risk taken, the expected return should be more than a unit.
8. Use of Derivatives
Derivative instruments like futures and options can be used to restrict the volatility to a great extent. The derivative instruments can be used for limiting losses and protecting profits.
For e.g. If you are going long on a particular stock, you can buy a put option on the same stock. If the prices go down, you can exercise the option contract to limit the losses.
Most experienced investors use futures and options as a risk management technique.
The premiums need to be paid if you wish to use derivatives. Hence, this may not be an ideal volatility reduction measure for new or small-scale investors.
9. Stay Invested/Do not Invest
When there is too much volatility in the market, the best decision can be to not do anything at all.
It is generally recommended not to buy or sell in a severely volatile market. Under such conditions, investors can stay invested or can stay completely away from the market for a while.
When the markets crash, the instruments are available at cheaper rates. This attracts value investors to the advantage of the opportunity to buy cheaper.
However, sometimes markets can further fall dramatically leading to losses.
Hence, it is always advisable to base the investment decisions on research and analysis rather than timing the market.
10. Long-Term Perspective
Investment is a long-term approach to wealth creation and appreciation. The volatility in the short term has historically appeared and vanished several times.
Although, the majority of the investment instruments have generated positive outcomes in the long term.
Short-term fluctuations must not interrupt the approach, objective, plan, and strategy created for long-term wealth gain.
Those who seek capital gains in a short duration should try trading strategies and should not depend on long-term investment strategies.
11. Consult a Professional
There is no shame in consulting an investment professional when you have lesser knowledge about financial markets.
Doctors, architects, and other professionals are always reached out when you do not have adequate knowledge of the subject.
Lack of knowledge about financial markets will increase the chances of making bad decisions.
These decisions can lead you to severe losses or unwanted outcomes.
It is better to spend a very small proportion on advisory rather than facing drastic losses.
An expert can not only suggest suitable instruments but will also guide you towards ideal volatility management techniques.