Conquering volatility

Volatility will rule the stock markets for some time. But instead of worrying, reaffirm your faith in long-term investing.

By Devangshu Datta        Print Edition: September 20, 2007

When you go shopping for vegetables, wouldn’t you be surprised if prices changed every few minutes? You would be irritated and wary and you may well decide
to switch markets and seek a wholesale market where the rates were more stable. You would certainly become a more discerning and calculating shopper if you had to buy your veggies under such conditions.

Of course, vegetable prices don’t fluctuate with minute-to-minute frequency. But stock prices do. They change continuously and the direction is random and unpredictable. On an average day, the Sensex swings around by over 2%. Individual stocks may move by over 3%. This continuous, unpredictable motion frightens many wannabe investors. Oddly, those who remain committed to share market investing don’t necessarily become more discerning or calculating shoppers.

Behavioural psychologists have puzzled over the fact that the same person, who will sensibly buy potatoes only when the price is low, will buy stocks only when the price is high. Common sense says that this is idiotic — yet it is the popular course of action. To cap it, people who buy high often get spooked by volatility into selling when prices are low. What is volatility? It is the rapid change in prices — in either direction. It is inherent to stock markets — share prices can change astonishingly in a very short time.

Many investors find this so scary that they exit the market forever. Others stay in the game but suffer insomnia every time prices twitch. Volatility is not necessarily a bad thing. When it brings prices down, it offers smart shoppers bargains.5 faces of the stock markets

When it sends prices spiking up, it gives bargain-hunters bigger returns. It is a fact of life in equity markets — and it is uncontrollable. To understand the double-edged implications, consider a practical case. On 31 January 2007, two investors buy Tata Steel. On 30 April 2007, they both sell, punching in “at-market” orders.

One gets a return of 16.35% while the other gets a return of -13.9%. Why the difference? Well, on 31 January, Tata Steel made a high of Rs 539 and a low of Rs 461 and on 30 April, it had a high-low range of Rs 536.5 and Rs 464. One investor bought at the high on 31 January and sold at the low on 30 April while the other bought at the low and sold at the high. One was a victim of volatility; the other was a gainer from it. Neither investor had control over his returns.

A very smart, very committed, full-time trader may be able to finetune trades to exploit such volatile situations to the hilt. But as an investor, you should not even try to time price swings. The difference in attitude between a trader and an investor is not always understood. Think of the trader as the shorthaul commuter who hangs out of a train trying to get to the next station in a hurry. He takes risks, suffers discomfort and frets every time the train slows down. The investor in contrast, is a long-distance passenger who books his reservation in advance and sleeps in comfort as the train chugs along until it reaches its destination.

Of course, you should be aware of the impact volatility can have on returns. Returns from equity can never be accurately predicted. Volatility creates inevitable error margins and that should be incorporated into your financial planning. The best action in the face of volatility is often inaction. Ignore it when seeking long-term returns. Once you have picked a good business, work out the maximum price you are prepared to pay, based on the intrinsic value of the business and its growth prospects.

As the two doyens of long-term investment suggest, you should buy only when a share is available below your estimate of intrinsic value, thus offering a margin of safety. Once you have bought, ignore price swings. You should be prepared to hold forever. Sell only if you think the long-term prospects are deteriorating or the share price is too high. This buy-and-hold method is how successful investors make their fortunes.

Good businesses can offer great returns over decades, sometimes over centuries. Tata Steel has just celebrated its first century. ITC is almost as old. So are Hindustan Unilever and Colgate. Even a relatively young company like Reliance Industries has been around for more than 30 years and sunrise businesses like Dr Reddy's and Infosys got listed over 10 years ago.

If a business is founded on sound principles, run efficiently, and moves with the times, there is no reason it would ever cease to make profits. General Electric, the creation of inventor Thomas Alva Edison, was one of the original 30 stocks in the first-ever stock index, the Dow Jones Industrial Average (1907). A hundred years later, GE is still one of the world’s premier companies and still part of the DJIA. Of course, the larger a business becomes, the more difficult it is to inject growth. Nevertheless, it will continue to be a cash cow. When you identify a business which promises long-term payback, it makes sense to buy another chunk every time the price is right.

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