Align portfolios to long-term objectives to deal with volatility

Volatility is a statistical measure of the dispersion of returns for a given security or market index. Commonly, the higher the volatility, the riskier the security. Volatility refers to the amount of uncertainty or risk related to the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security's value does not fluctuate dramatically, and tends to be more steady.

Quantitative and qualitative volatility

Volatility can be defined in both quantitative and qualitative terms. The quantitative nature means the quantum of correction or fall that happens in the markets. If it is of a high order then it leads to an erosion in the portfolio value all of a sudden, or even a sudden gain sometimes. The qualitative nature of volatility refers to the extent to which the volatility, which is one-sided, probably indicates a change in the fundamental direction of the markets. Volatility is sometimes a pre-cursor to markets changing the basic direction.

The recent volatility we have seen in both equity and debt in the domestic markets has been the result of the interplay of a variety of factors. The depreciation of the rupee, rise in crude prices, liquidity, rich valuations were the prime factors which have had an impact on the markets recently. All these factors directly or indirectly have the potential to push the domestic price level or inflation higher, and this in turn, leads to a rise in interest rates. While these factors were already known to the markets, what disturbed the markets was the developments around liquidity and credit risk. The inter-bank market had challenges around liquidity deficit and the Reserve Bank of India supplied liquidity through Open Market Operations. Then came the unexpected news of the default by IL&FS. This was further accentuated by bulk sales of Non-banking Finance Companies papers at relatively high yields, compared to the prevailing market rates. Housing finance companies became specific targets as they were perceived to be having asset liability mismatches. No doubt there has been a quick response by the authorities to calm things down.

All this while we are witnessing a consistent sell off by FIIs from the domestic markets. These developments impacted both debt and equity markets and resulted in volatility.

Traders love volatility, and often have short-term positions. They like the wide ranges within which the market moves as it helps them trade. But for a long-term investor the approach to volatility and the process of investing should be completely different.

Aligned portfolios with investors' risk profile

As far as investors are concerned there are two important aspects, in the context of volatility, that should be kept in mind. One, the portfolio should be always aligned to the basic risk profile of the investor. Profile based investing insulates the portfolio from the bad effects of volatility in the long run. The risk profile not only reflects one's capacity to invest, but also the general awareness of the markets and also the psychological disposition in times of distress like extra ordinary volatility.

Risk profiling also helps putting in place an appropriate asset allocation, the investment portfolio will be diversified over various asset classes. Therefore, undue volatility in one asset class will be more or less balanced out by stability which the other asset classes provide. If the portfolio is aligned to risk profile matched to a suitable asset allocation based on the investors profile, and a periodic portfolio review by one's advisor, it is less likely that volatility will take the wind out of one's sails. The portfolio, in short, needs to be harmonised with one's long-term objectives, which makes intermittent volatilities irrelevant to the portfolio objectives.

Profit booking, weeding out bad apples

Apart from these two basic anchors of your portfolio, there are two more things that one needs to look at, one - profit booking to realise the capital gains accumulated over time (if a view on the underlying holding changes), and two- weeding out the bad apples, if any, at the earliest and bringing in new products in its place.

If these prescriptions are followed closely, one will find that volatility, quite often, offers an opportunity to buy into markets as the markets correct. In that sense, and to some extent, volatility is a boon for investors.

RISK PROFILING

• Risk profile is one’s capacity to invest, general awareness of markets, psychological disposition
   
• Diversify over various asset classes based on risk profile

The author is CEO, Emkay Wealth Management