How Investors Can Make The Most Of Market Volatility

Equity markets have been on a roller-coaster ride this week. After posting one of the largest single day falls (roughly 6%) on Monday, today markets staged a minor recovery of sorts. Not surprisingly, business channels and newspapers are dissecting every market development in great detail. Experts are busy predicting where markets are headed next. On their part, investors are tuned in with rapt attention.

While investors’ engagement with the external environment is understandable, this is indeed the right time to do some soul searching. The latter can prove to be the proverbial silver lining in this phase of market volatility. Surprised? Read on.

Equity investing is not without risk given the uncertainties involved; over shorter time frames, the risk is further accentuated given that even extraneous factors can significantly impact stock prices. As a result, while investing in equities/equity-linked products, one needs to be able to take on a certain degree of risk. This in turn necessitates an accurate assessment of one’s risk appetite. Sadly, that is easier said than done. When markets are rising, investors can erroneously start believing that it is easy to make money in the markets. This can lead to an inflated notion of one’s risk-taking ability. 

Harsh as it sounds, a volatile phase like the present one can provide a much-needed reality check. Now is the time to revisit your assessment of the risk you can take on. Ask yourself if you are yet as comfortable with equity investing as you were when markets scaled record highs earlier in the year. While an investment advisor can help with this exercise, you will have to play the most important part. If an honest introspection reveals that you have jumped the gun, don’t worry. All you need to do is rejig the portfolio so that it aptly reflects your risk appetite.

This is also a good time to evaluate if you’ve fallen prey to the ‘Keeping up with the Joneses’ blunder. At times, because a friend, relative or colleague claims to have done well with his equity investments, investors feel the urge to emulate his investments. The trouble with this approach is that it violates a basic tenet of investing. At its core, investing is a personalised activity. Investments have to be right for the investor in question. Hence, adopting the ‘one-size-fits-all’ approach can lead to unpleasant results. 

For instance, the friend (whose investments you have copied) may have a portfolio dominated by equities, since he has an investment horizon of a decade; conversely, you may have an investment horizon of just three years. In such a scenario, replicating his investment pattern wouldn’t be the best option. Yet again, it takes a bout of volatility to expose this inherently flawed investment practice.

Admittedly, market volatility can be a bitter pill to swallow. But the fact remains that while investing in equities, it comes with the territory. Rather than fretting over it, investors would do well to embrace volatility, and use it to their advantage by sharpening their investments.

Do your mutual funds stand the test of character?

'In times of adversity, true character is revealed' - that's an adage relevant not only to humans, but also investment avenues like mutual funds. Any analyst worth his salt will vouch for the fact that in rising markets, it is hard to distinguish the men (proven and invest-worthy funds) from the boys (also-rans). Buoyed by conducive market conditions, even mediocre funds can deliver an extraordinary performance. Often the mantra is - take on above-average risk and ride the wave.

But when the tide turns (as it has over the past 12-14 months), a fund's mettle is truly tested. The last few months have been particularly interesting. With the markets hovering around the 8,000-point mark, despondency had all but set in. And then came an uptick that took everyone by surprise. Speculation regarding 'the worst being over' and 'the commencement of a recovery' was doing the rounds. But alas, the victory celebrations seem to have been interrupted by the impending election results and the possibility of another hung parliament.

If you are an investor, it can be safely stated that these aren't happy times. The uncertainty is certainly not helping. But all is not lost. On the contrary, this is an opportune time to evaluate your mutual fund portfolio.

The evaluation needs to go beyond the obvious i.e. how a given fund fared on the downside. Sure, the latter is important and will play a significant part in the process. However, an equally vital evaluation will pertain to identifying the fund's 'true character'.

Each fund has a professed investment style; in mutual fund parlance, this is referred to as the fund's positioning. Say Fund A in your portfolio may be positioned as a mid cap fund. Now is the time to determine if the fund manager has walked the line and adhered to the stated investment style i.e. irrespective of the market conditions, does the fund continue to be invested in mid cap stocks in line with its investment objective/positioning.

There will be a case for raising a red flag if you come across the professed mid cap fund making substantial investments in the large cap segment, simply because the latter has been less impacted during the downturn.

Then there are funds which state that they will be fully invested at all times i.e. they will refrain from taking cash calls. This investment style often flows from the philosophy that fund houses are custodians of investors' monies for investment purpose as opposed to holding cash (making investments in current assets).

The red flag scenario: A fund house which believes in holding portfolios that are fully invested at all times, performs a volte-face and holds a substantial portion of its portfolios in cash to minimise the brunt of falling markets.

Hybrids i.e. balanced funds and monthly income plans (MIPs) are often referred to as tools of asset allocation, on account of investments in both equities and debt. Theoretically, by diversifying across asset classes, hybrids are better equipped to safeguard the investor's interest when a given asset class hits a rough patch. When equity markets run into rough weather, a balanced fund can score over a conventional equity fund on account of its debt holdings.

Now is the time to find out if the hybrids in your portfolio are playing their part as required. Failing to do so (say a balanced fund that insists on being largely invested in equities akin to a conventional equity fund) defeats the purpose of investing in a hybrid.

Why it is vital to conduct the aforementioned exercise
Wondering why it is vital to conduct the aforementioned exercise (incidentally, the above list is not a comprehensive one; these are some among several tests that can reveal a fund's true character). Another question could be that some of the 'red flag' scenarios were aimed at protecting investors' interests. Hence the same should not be held against the fund house. Here's why this argument doesn't hold good.

A fund is not an 'end', it is simply a 'means' to achieve an end. In other words, the fund should find place in a portfolio because it can play a specific part. And the part played by the fund is inextricably linked to its nature/unique characteristics. Should the fund deviate from its defined character, there's a fair chance that the portfolio might fail to deliver on expected lines and in turn, the investor may fail to achieve his financial goals.

What you must do
As an investor, you must ensure that you are invested in funds that have a defined character and a reputation of not having deviated from the same. Furthermore, once the investments are made, a review of the funds' performance (including adherence to their stated investment style) must be made. The financial planner/mutual fund advisor will have a critical role to play in the review process; expectedly, the same must be conducted on an ongoing basis over a period of time. The advisor will be equipped to distinguish minor aberrations from significant deviations. And given the challenging investment scenario we are faced with at present, the resolve of even the most resolute fund houses and fund managers is likely to be tested. Hence, the importance of conducting a thorough review now!