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Risk and volatility may discourage lots of people from investing. But history tells, that the financial market may be a huge vehicle of long term wealth. So the question is how to deal with market risk and uncertainty, which are always actual in both investing and business. A deep understanding of the market's nature isn’t just helpful. It's essential. Let’s dive in.
Market volatility is influenced by economic news, global events, and investors psychology. It can be measured using indicators like the VIX index. Building a stable investment portfolio requires diversification across asset classes, investment in fixed income and alternative investments to mitigate stock market risks.
Volatility may be risky, but market fluctuations are a regular part of investing. Understanding this can help to remain calm and make more informed decisions. Keep abreast of financial news and market trends, but avoid making decisions based on emotions. Reacting impulsively can harm any investment strategy. Investors should understand crucial factors such as uncertainty and risk of every investment decision;
Focus on long-term financial goals rather than short-term market performance. Historically, the market has shown a tendency to grow over time. Dollar-cost averaging, the strategy of regularly investing a fixed amount, can help you to buy more shares when prices are low and less when prices are high.
Remember that nothing is guaranteed, the future is unknown and many random events hit global markets, every day. What's more, another bear market is highly probable in the future, but that doesn't mean that you should prepare for it now and always be defensive. Defensive portfolios usually underperform more aggressively during bull runs. Think about diversification.
Volatility is the heartbeat of the stock market. A rhythm that ebbs and flows with the pulse of global events and economic news. The term “market volatility” refers to the range of price changes that stocks and other securities experience over time. It’s an expression of the market’s temperament, swinging between periods of rapid growth and sudden decline.
High volatility means the price of a security can change dramatically over a short period in either direction, while low volatility means the price is relatively stable. Usually, market panics are much more volatile (and shorter) than bull market trends. That’s why volatility usually increases, when investor sentiments weaken. It’s also the reason why VIX is named “fear index”, however it doesn’t measure fear. It measures the stock market's expectation of volatility based on S&P 500 index options. But what causes these waves of market risk to rise and fall? And how can we quantify their impact on our investments?
SP500 total return and VIX volatility index from 2000
Historically, CBOE Volatility Index (VIX) rose along with downtrends seen in the S & P 500. VIX is also analysed as a very good benchmark of expected volatility, across the broad financial markets. Past performance does not guarantee future results. Source: XTB Research, Bloomberg Finance L.P.
Navigating the investment waters also requires a keen understanding of risk management techniques. In volatile markets, it may be pivotal to investment success as spotting a profitable opportunity. There are no magic formulas, but some strategies may support overall portfolio performance, by limiting downside risk. Remember that financial markets are created by human (buyers and sellers) reactions to data and news. Those reactions are hard to predict. Unexpected events happen every day in the world, potentially hitting companies' valuations and risk perception. Uncertainty leads to market excesses - panic and euphoria.
Defensive orders are akin to a safety net, designed to protect your trades from falling too far. By setting a specific price at which a stock is to be sold, by setting a sell stop order as well as stop-loss orders on the futures market can significantly reduce the potential for large losses. These orders work automatically, providing peace of mind and convenience for investors who cannot monitor their stocks daily.
Hedging strategies are the financial equivalent of weatherproofing your portfolio. By using instruments such as options and inverse ETFs, investors can shield their investments from market downturns and even enhance profits during periods of high volatility. The protective put, for instance, is a popular hedging mechanism used to guard against losses in an existing stock or portfolio.
Instruments that track the VIX (for example Amundi S&P 500 VIX Futures Enhanced Roll UCITS ETF Acc) are particularly useful in hedging strategies, as they:
Important: Diversification doesn’t mean exposure to stocks from the same sector or with the same supplier. For example, if any investor invests in companies, which have almost 100% factory capabilities in China, they are all exposed to the same risk. Diversification should mean collecting assets from different sectors, which may be uncorrelated or give a hedging potential if any risk event attempts. As an example, we can use exposure to technology companies, which may lose among geopolitical tensions. A well diversified investor may also have oil companies in such a portfolio, which may limit losses on technology or even outperform, during that period; with limited downside potential if geopolitical tension eases.
Swing trading is the strategy of choice for those looking to profit from short-term price movements. By identifying potential reversal points in the market, swing traders can ride the waves of market volatility to their advantage.
Dollar-cost averaging serves as a steady hand in the unpredictable seas of market volatility. By consistently investing a fixed amount of money at regular intervals, investors can avoid the dangers of market timing and benefit from purchasing more shares when prices are low.
To steer a steady course, investors need to familiarise themselves with a range of economic indicators that act as navigational stars.
Sailing through the investment seas requires not just setting a course, but also making periodic adjustments to maintain the desired direction. Rebalancing a portfolio is the act of realigning the weight of each asset class to match the targeted asset allocation. This process often involves selling assets that have grown disproportionately and buying underrepresented assets to ensure the portfolio continues to align with an investor’s risk tolerance and financial objectives.
Investors typically rebalance their portfolios using set time intervals or when the percentage change in asset class weights reaches a predetermined threshold. However, rebalancing doesn’t necessarily require selling existing assets; it can also be accomplished using new funds or reinvested dividends. Regular rebalancing not only manages risk levels but also ensures that investments remain in sync with long-term goals, adjusting to realistic market expectations as necessary.
As our voyage through the fluid landscape of market volatility comes to a close, we reflect on the key strategies that have been charted. Understanding and measuring market volatility allows investors to anticipate and prepare for the capriciousness of the stock markets. The auction-driven market has the tendency to excess: panic and euphoria. Both reflect in asset prices. Constructing a resilient portfolio through diversification and incorporating fixed income and alternative investments creates a bulwark against market upheavals. Embracing a long-term investment perspective, underpinned by discipline and risk management techniques, provides a stable path through the tempests of market swings.
By adopting these strategies, investors can better manage their reactions to market volatility, making it a part of their investment journey rather than a roadblock. Remember, volatility is a normal part of investing; embracing it with a well-thought-out strategy can even uncover opportunities for growth.
Emotions such as optimism, excitement, fear, and panic can lead to buying high and selling low in investments. This emotional impact can cause investors to make suboptimal decisions and underestimate risks, ultimately affecting their investment outcomes.
To take the emotion out of investing, diversify your portfolio to reduce the impact of market swings and avoid getting emotionally attached to your investments.
An example of emotional investing is when investors make decisions based on what others are doing, such as buying a particular stock just because everyone else is doing it, even if it doesn't align with their long-term investment plan.
Having a solid investment plan is crucial, as it provides structure and reduces the likelihood of making impulsive financial decisions. It guides your choices and helps to minimise emotional influence.
Reducing volatility can be achieved by diversifying investments across different assets, which helps smooth out returns and lowers unnecessary risk. On the other hand, there is no one, guaranteed strategy, which limits volatility, without limit potential investments returns. Volatility is especially a dilemma for active traders, then long term investors.
Diversification strategies help during bear markets by spreading investments across different assets, industries, and regions, which minimises the impact of a downturn in any single area on the overall portfolio. This helps to reduce risk and protect against significant losses.
This content has been created by XTB S.A. This service is provided by XTB S.A., with its registered office in Warsaw, at Prosta 67, 00-838 Warsaw, Poland, entered in the register of entrepreneurs of the National Court Register (Krajowy Rejestr Sądowy) conducted by District Court for the Capital City of Warsaw, XII Commercial Division of the National Court Register under KRS number 0000217580, REGON number 015803782 and Tax Identification Number (NIP) 527-24-43-955, with the fully paid up share capital in the amount of PLN 5.869.181,75. XTB S.A. conducts brokerage activities on the basis of the license granted by Polish Securities and Exchange Commission on 8th November 2005 No. DDM-M-4021-57-1/2005 and is supervised by Polish Supervision Authority.
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