What is volatility?
Generally risk in markets is described by a measure called volatility, which is a tendency of securities to increase or decrease abruptly in a short period of time. It measures the standard deviation of rates of return of the investment. Volatile markets are characterized by extreme price changes and large trading volumes. This is usually caused by company news, rating changes, economic data releases, IPOs, surprise earning announcements, etc. While volatility is inevitable, there exists several ways to alleviate the adverse effects during these times, such as diversifying, using limit orders, investing regularly, etc.
Diversification within asset classes, different industries, company sizes, locations – these are all benefits that can lessen the impact of high volatility. While during volatile markets some security prices will go down, the others will move up, thus reducing the impact of unexpected drop in prices and offsetting the losses. Diversification is probably the most important mechanism to limit the diverse consequences during bad times.
Use Limit Orders
When the stock price fluctuate significantly, the type of order you use is extremely important for getting the transaction executed at the desired price. While the market orders will be always executed, the price that you actually get during volatile markets can substantially deviate from the quoted ones.
In this cases it is better to use limit orders, which is an order to buy or sell a predetermined amount of shares at or better than a stated price. While this type of orders usually will cost you a bit more compared to the market orders and doesn’t guarantee execution, it is worth to use them to be sure that the transaction will be done at a specified price.
Some investors try to time the market, that is move in during good periods and out during bad periods. Based on the research implemented by Morningstar, it is not worth it; it is very costly and almost all the time investors find themselves worse off.
The alternative is to invest regularly over days, months and years. By doing this you can lessen the adverse effect of short-term downturns and protect your portfolio.
Take advantage of opportunities
While one can get frustrated by short-term downturns, others use that situation for their benefit. For example, you can invest long-term in securities that are substantially depreciated during those times or take advantage of selling part of the holding with a realized loss to help you with tax planning.
Volatility is unavoidable. You have to be comfortable with your strategy. Don’t rush into changing your decision based on abrupt swings in market prices. Many investors find it very difficult to stay calm during the day noticing huge price fluctuation minute by minute. Checking your portfolio every second will only make you more nervous. Try to make yourself comfortable to the fact that these swings are inevitable and your long term strategy has nothing to do with those short-term fluctuations.