The coming months look set to witness heightened volatility after the announcement of Lok Sabha poll schedule. Warren Buffet had once famously said, "The years ahead will occasionally deliver major market declines- even panics- that will virtually affect all stocks. No one can tell you when these traumas will occur. But over the long term, there's only one direction that the market will go".
This is just the right time to rely on his wisdom. A sharp correction in the broader markets has kept investors on tenterhooks for the most part of 2018 and the beginning of this year as well.
Markets have been peppered with intermittent volatility and many investors have chosen to sit on the fence since no clear trend seems to be emerging. Volatility can have a strong influence on investor behaviour and can impact his/her ability to make rational investment decisions.
Various studies have concluded that market volatility, investment prices and associated risk have a strong correlation. It has been observed that in volatile market conditions investors often panic and withdraw investments in an attempt to avoid risk, only to return as active investors closer to peaks, when markets are trending and therefore, less volatile.
Consequently, they end up making losses. Therefore, it is imperative to be aware of the inconsistent and unpredictable nature of markets and make investment decisions in a rational and disciplined manner. It is equally important to build a portfolio that is tethered to a robust asset allocation policy so that the adverse impact of extreme market volatility on portfolio returns can be mitigated.
Simple is Best
The simplest thing that one can do in such an environment is 'Stay Invested'. Often, short-term movements in an asset are largely influenced by sentiment and have little or no impact on the long-term potential of the asset. Long-term investing can smoothen the impact of the ebbs and flows of the markets and help investors reap the true potential of their investments.
The downturn may last for a few days or even a few months but eventually recovery is bound to happen. All an investor needs to do is be patient and stick to the pre-decided asset allocations that are meant to achieve their long-term investment objectives.
Clear-Cut Asset Allocation
The foundation for building a robust portfolio lies in crafting a clear and precise asset allocation policy. In volatile times, it is this policy that comes to the rescue of the investor. In fact, asset allocation is the most important determinant of portfolio performance- way ahead of market timing and security selection.
In a study conducted in the Financial Analyst Journal, 91.5% of the portfolio performance was attributed to Asset Allocation, far higher than security selection which was 4.6% and market timing which was 1.8%.
It is also essential that asset allocation must be aligned to the financial goals of the investor. An investor with a shorter time horizon or an approaching goal should have a relatively less risky portfolio. Having said that tactical decisions must be taken to exploit mispriced opportunities after evaluating current market conditions.
However, financial discipline must be maintained over the entire market cycle. For instance, if overall equity market valuations become very expensive, it would be wise to move to safer large cap bets or principal protected structured products, but such decisions must be made keeping in mind that overall asset allocation remains intact.
Diversification holds the key
It is important to diversify across asset classes. To reduce the overall volatility of the investor portfolio, one can invest in multiple asset classes with low correlations. Bond yields and stock returns have spent much of the past decade being positively correlated.
However, there are now various investment products available in the market that come with their own idiosyncratic risk/return characteristics and can ably meet the portfolio diversification needs of an investor. Investors can now consider allocating their funds to alternative asset classes like Real Estate, Private Equity, Commodities etc.
These asset classes typically provide diversification benefits as they have lower correlations with traditional Equity and Fixed Income portfolios.
Few of these asset classes suffer from drawbacks like large ticket size, lower liquidity and lesser transparency and hence require domain experts to find the correct opportunities.
However, well researched investments in these asset classes can help investors manage volatility in their portfolios. In this way, losses in one particular asset class can be offset by gains in the other asset classes or losses can be contained to some parts of the portfolio. One should also look to diversify within asset classes. It would be unwise to have a large allocation to a specific sector within the portfolio.
Volatility is a part and parcel of investing. In most times, all the investor should do is to stay put ignoring all the noise around.
(The author is Senior Managing Partner and Chief Investment Officer, IIFL Investment Managers)