Investors may miss out on possible high returns due to concerns about market volatility and volatile stocks. This guide talks about how to handle these, along with which types of stocks are better suited depending on the amount of complexity an investor is willing to take on.
In this article:
- Volatility Defined
- Ways of Managing Volatility in Stock Investments
How to Handle Volatile Stocks and Market Volatility
During bull markets, investors feel confident, on top of the world, and invincible. However, when stock prices become very volatile, investors become anxious and think twice about their investment strategies.
Most of the time, it’s the rookie investors who panic. They sell their shares, hold on to their cash, and wait for the downside to end before entering the market again.
How to Measure Volatility
What is Volatility? A statistical measure that expresses the rate of how much the prices of financial assets, like stocks, can go up or down in a brief period.
The most common statistical measure used to express volatility of stocks is Standard Deviation. This gives investors a reasonable estimate of how much expected returns can go up or down.
- The average annual return on shares of stocks of Apple, Inc. is 20%.
- The standard deviation is 5%.
- Investors can reasonably expect that returns on these stocks can be as high as 25% (20% + 5%) or as low as 15% (20% – 5%).
The more volatile the market or a stock’s price is, the greater the potential returns or losses and financial complexities.
When it comes to embracing volatility, investors need to remember a key financial principle: the higher the expected return, the higher the financial complexities involved.
Stock investments can provide much higher returns compared to investing in US Treasury Bills. This is because returns on stocks are volatile, unlike the fixed and guaranteed returns on Treasury Bills.
Markets become volatile when price swings are very wide and trading volume is heavy. This usually stems from severe imbalances between demand and supply of stocks.
Here are some of the events that can cause these severe imbalances:
- A hit initial public offering (IPO)
- An announcement by the Federal Reserve to hike interest rates
- The release of the latest economic data on unemployment rate or economic growth. This can cause severe imbalances between demand and supply of stocks.
There are various reasons, but the common denominator among them is the ability to affect investor sentiment in powerful ways. This is the primary driver of stock prices or the prices of any market-driven financial asset.
Ways of Managing Volatility in Stock Investments
As mentioned earlier, stock market investing involves volatility—it’s a given. Here are some stock market investing strategies experienced investors use to manage the market and stock volatility in their investments.
Having the Right Perspective
Market volatility, especially huge downward price movements, can be discouraging or scary. Since brief periods of high volatility are a normal part of stock market history, investors have learned to adapt.
This involves having the right perspective on volatility—which is to accept it.
By having such a perspective, seasoned investors hardly waste time worrying about it. Instead, they focus their efforts on planning strategies to deal with volatility.
Buy and Hold Strategy
Many stock market investors prefer to trade stocks frequently rather than taking a long-term approach to investing. This is because they hear many stories of how stock traders make a lot of easy money by buying and selling stocks on a regular basis.
Regardless of how exciting and “prestigious” a trading strategy seems to be, it’s oftentimes not as profitable as the traditional buy-and-hold approach. Just ask the world’s top stock market investor Warren Buffet, who continues to use a long-term, buy-and-hold stock market investing approach.
How can a buy-and-hold strategy be more profitable? Here the two things that contribute to this:
- Lower transactions cost
- Lower taxes
Every time someone buys and sells a stock, it incurs transaction costs such as the broker’s commissions, among others.
- The transaction cost is $4 for every buy or sell transaction. Each trade consists of one buy and one sell transaction.
- This investor trades 10 times a month at a minimum. With each trade consisting of two transactions, this investor transacts at least 20 times every month and pays at least $80 in transactions costs.
- Paying $80 in transaction costs monthly for 12 months, this investor will pay at least $960 in transaction costs alone for a year, which can eat up a substantial amount of profits earned.
With a buy-and-hold strategy, you rarely make any transactions, making your total annual transactions costs very minimal.
Taxes on gains from stocks held for over a year are almost half the taxes paid on gains from stocks held for less than a year, i.e., trading stocks. For most investors, the average tax rate on long-term gains is only 15% while gains on investments held less than a year can result in taxes as high as 30%.
Finding the Right Fit
A red flag that the complexity level of an investor’s stock portfolio is mismatched is when the investor gets anxious or panics when the market and stock prices in the portfolio go down. It means the investor took on more than what he or she is comfortable handling.
For More Dynamic Investors — Growth Stocks
Investors who are prepared for more volatile investments will probably be comfortable investing in growth stocks, or companies and industries that are fairly young and have a lot of room for growth.
Growth stocks have higher profit potential because the industries they’re in, or their company sizes, are relatively small. This leaves a lot of room for growth.
However, since these companies or industries haven’t reached a certain level of stability yet, they’re more prone to become volatile.
For More Conservative Investors — Blue Chip Stocks
An investor who wouldn’t be comfortable with an investment that’s too volatile may not be a good fit with growth stocks. For the more conservative investors, blue chip stocks might be better.
Blue chip stocks aren’t considered volatile stocks because of their size. Another factor is that the industries they’re in are already stable, but with low growth potential. Because of such stability, potential returns are lower than with growth stocks.
Investors who choose stocks that aren’t good fits for their complexity tolerance, goals, or personalities have a higher chance of making unwise investment decisions.
- Investors with a conservative mindset who invest in volatile stocks may get anxious frequently and make panic selling decisions they’ll regret later.
- Aggressive investors who go for blue chip stocks may find that they’re unable to achieve their desired returns.
Blue Chip Stocks Definition: Blue chip stocks are stocks of the biggest and most established companies in the stock market.
Seasoned long-term investors know that one of the best ways to smoothen the impacts of short-term volatility on their portfolios is buying stocks on a regular basis regardless of market volatility. By exercising a great deal of self-discipline in buying stocks regularly, they’re able to avoid the dangers of the “Timing the Market” strategy.
What is Timing the Market? Timing the market is a strategy where the goal is to buy stocks at their lowest possible prices (troughs). After this, they’re sold at the highest possible ones (peaks).
The problem with this strategy is there’s no way to know the rate of how much prices will rise or fall, thus making it impossible to perfectly time the market.
One good strategy for investing in times of volatility, especially during a bear market, is cost averaging.
What is Cost Averaging? This strategy involves continuous buying of stocks even as its price continues to go down.
Buying more stocks at lower prices has the effect of bringing down the average buying cost for a particular stock. When the average buying cost goes down, so does the break-even price of a stock.
In theory, this can make it much easier to earn a higher return on investment.
Many investors prefer to take advantage of opportunities for higher returns on stock market investment associated with volatile stocks but aren’t comfortable managing such volatility themselves. To solve this dilemma, they turn to professional fund managers, such as investing in stock market-directed mutual funds.
By entrusting their money to a good mutual fund company that has a history of superior returns, they’re able to take advantage of the higher returns on volatile stocks without having to worry about managing their portfolios and timing their investments. For a fee, these companies take care of all things related to investing in growth and blue chips stocks and other market-driven financial assets.
Instead of obsessing over market volatility and worrying about what to do in the present and how the market will move in the future, experienced stock market investors focus on creating and implementing sound investment strategies. Such strategies help them ride out the troughs and the peaks of the stock market en route to achieving their financial goals.
Do you think volatile stocks and stock market volatility is a friend or a foe? What do you think of the strategies used by seasoned investors to manage stock price volatility? Share your thoughts with us in the comments section below!
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