Investing in volatile markets is like riding a roller coaster. The ups and downs are exhilarating but too much can leave you sick to your stomach.
Volatile markets can either make you a ton of money or break your portfolio into smithereens. But, unlike roller coasters, you are not at the mercy of the operator.
In volatile markets, you can draw your own destiny.
Every investor is different. But in this article, we explore how you can invest in volatile markets and make volatility work to your advantage.
Investing when the Market is Volatile: is it a good idea?
The most experienced investors often profit from market volatility. However, this carries significant risks.
The average investor won’t have access to the same level of tools and information as institutional investors, so instead, let’s discuss tips on how to mitigate market risk.
The most important thing to remember is not to immediately sell your investments to cash when you see them drop.
A study from J.P. Morgan found that most of the best days in the market simultaneously happen around the worst days (mostly after). If you miss the 10 best days over the last two decades by going in and out of the market, you would have only generated half of the returns than when you are fully invested the whole time!
How volatility can affect investing
From lack of liquidity to technical and bureaucratic inconveniences. Investing when the market is erratic can bring problems you better consider.
But volatility can also mean opportunity.
Take the Total US Market Research Index, for example. Between 1926 - 2020, the average annual returns for the five years after a 10 to 30% decline is around 10%. We see this trend also with the S&P 500 in the same period.
What this shows is that markets recover. This does not mean, however, that you should start frantically investing during volatile markets. Despite the recovery, some companies or investments could not recuperate even after the dust settled.
As much as you should not be a paralyzed pessimist when it comes to volatility, you should also be a careful optimist while rationally following a strategy.
How To Recognize The Signs of Volatility
Should I buy?
Generally speaking, it is good to buy when prices fall, but don’t just throw away all your notes and invest on a whim. So it would be best if you always looked to ensure that these are solid investments.
Warren Buffett even highlights that net buyers profit the most when the market dips, as it allows them to purchase stocks at a discounted value.
We are taking the long view here, and short-term volatility, often the cause for lower market prices, does not matter when figuring out the best investment time.
Searching for the bottom is not an investment strategy unless you can predict the future.
Your time in the market is key to investing profitably, not your timing in the market.
Should I sell?
In general, you should look to avoid selling based on blips on the market. More importantly, avoid panic selling.
Selling prematurely can make temporary losses permanent.
This does not mean you should hold on to investments blindly, but instead, logically evaluate how your investments and portfolio can play out in the future.
If evaluating each part of your portfolio is too much effort, you can always opt for automated investing. You can invest in index funds, ETFs, or proven AI-based trading engines like Peccala.
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How to Deal with Market Volatility
Review your risk tolerance and capacity
Risk tolerance is your ability to stomach big market fluctuations. If seeing your portfolio constantly move like a seesaw is too nerve-wracking, you should then match your portfolio to the risk levels you’re comfortable with.
Whereas risk tolerance is more of a mental concept, risk capacity, on the other hand, measures how much risk you can afford.
Do you have enough funds to cover near-term expenses or goals? The money you will need soon should be kept accessible. Keep them in stable, high-yield savings accounts.
The rule of thumb here is to only invest the amount you don’t mind losing and in assets that allow you to sleep well at night. We don’t mean you will end up losing money. But, if all your investments fail, you should have enough cushion to fall back on.
Limit losses
One way to protect yourself from market drops is to hedge against them. You can, for example, buy put options on the stocks or index funds/ETFs you are investing in. In doing this, you gain the right (but not the obligation) to sell your shares of the underlying at a set price on or before the contract of the option expires.
To put this into perspective, let’s say that you hold ABC stock trading at $100, and you want to protect yourself from losses of more than 15%. You could then buy an $85 strike put. Even if ABC stock falls to $70 or even lower, your put option allows you to sell your stock at exactly $85. This decision saves you from a further loss of $15 or more!
Include defensive assets
Defensive assets like cash, cash equivalents, gold, and treasury bonds, can help offset the volatility of your portfolio when stocks are falling. These assets can diversify your portfolio and smooth out risk over time.
Limiting downside risk becomes even more important as you progress through being a long-term investor. Diversification is not a silver bullet, but evaluating the mix and match of your portfolio protects it from wild swings in the long run.
Remember, investing is a marathon, not a sprint. There is no use getting incredible gains from high-risk and volatile investments if you could lose it all the moment after.
Strategies to Profit from Volatile Markets
Aside from asset allocating and diversifying, here are some investment strategies you can follow to take advantage of volatile markets.
Market Neutral Strategy
In a Market Neutral Strategy, you buy undervalued stocks and sell/short overvalued ones in similar sectors/industries with comparable market caps.
In this market plan, you profit from leveraging differences in stock prices by being both long and short in similar stocks. This means volatility in the overall market becomes a non-factor.
To do this, a market-neutral strategist will either employ fundamental arbitrage or statistical arbitrage. Fundamental arbitrage employs the use of fundamental analysis to project a company’s long-term profitability, while statistical arbitrage uses quantitative algorithms to uncover undervalued stocks and price trends based on historical data.
This strategy works especially well if you have prior knowledge of the sector you’ve chosen, as it increases your chances of making profitable investments.
Non-directional Investing
Non-directional investing is exactly what it sounds like. You make money in any direction or in any market - up or down, bull or bear.
Most investors follow directional investing (think investing bullish or bearish, depending on the chosen strategy). The problem is that when high volatility strikes, the momentum gained can be wiped out in a matter of days along with the gains you earned.
In non-directional investing, you will profit from the volatility of the asset instead.
The beauty here is that you have scores of strategies to choose from (like butterfly spread or straddle/strangle), and you can challenge your creativity and analysis on how to use them.
Straddle Strategy
A straddle is an options strategy involving you buying both a put option and a call option at the same strike price and expiration date of the same asset.
What does this mean and how do you profit from this?
This strategy thrives in volatile markets. By buying both put and call options, your capital is protected whether the asset goes down or goes up, But, if the asset swings more than the premium you have paid for the options, then that’s the profit you gain.
