Volatility is ruling the roost in global equity markets currently and it is not unusual to see equity prices slithering down to touch low levels in one trading session while scaling up in another. The recent "flash crash" in the US with the Dow Jones industrial average shedding close to 1000 points and wiping off around $1 trillion (Dh3.67trn) of market capitalisation within 15 minutes and then recovering almost as quickly, has brought to the fore how volatility can throw stock trading out of gear.
With worries over the economic recovery and Europe's debt concerns still weighing on investors' sentiments, a large number of stock investors are still groping in the dark over the fate of their investments. Especially, during volatile times and choppy trading sessions, stock markets can really make equity investors jittery.
But then, at the end of the day, a stock market investment is both a dicey as well as a money-making venture, and volatility is very much a part of stock trading. So how would you understand volatility in stocks is affecting returns on your stocks?
"If you buy a stock with a high volatility, it could go up or down a lot in the short term, whereas a stock with low volatility is likely to experience much smaller moves," said Paul Cooper, Managing Director, Sarasin-Alpen and Partners, Dubai.
It is entirely possible, of course, that an asset with low volatility outperforms an asset with high volatility, as was the case with cash and equities in 2008. One normally associates high volatility with high return, but the likelihood of this happening is positively correlated to the length of time you can invest. That is why we recommend clients to buy equities only if they have a medium or long-term investment horizon, he said.
Stay invested for long term
Analysts say volatility, in any case, is bad news for any class of investors, because when the market moves up and down, it tends to worry investors prompting them to take wrong decisions. Volatility often leads to panic selling when the market is bearish, and to aggressive buying when the market is going up in the hope of making money out of the volatility. However, studies have shown that investors do not make money out of market timing, ie jumping in and out in the hope of buying cheaper. Hence, it is better to invest for longer term and not to play the up and down cycles, said Gary Dugan, Chief Investment Officer, Private Banking, Emirates NBD.
Volatility tends to subtract from stock market performance for two reasons. First of all, due to the complacency issue where investors are simply becoming too optimistic when stock market prices are exhibiting lower and lower volatility. The second reason is grounded in simple arithmetic and the fact that volatility in returns (especially important for the trading community) subtracts from overall performance, said David Karsbol, Chief Economist, Saxo Bank.
He says investors need to think about the impact of volatility in their trading and portfolio management. For example, if you trade a portfolio of $1 million a 100 times where every second trade is a loss of 10 per cent and every second trade is a profit of 11 per cent, the average trade will be a profit of 0.5 per cent, but after the 100 trades, you will still be down almost five per cent in total.
Another important factor to know, experts say, is that volatility is about sentiment, or what the market thinks, rather than logical explanations.
People do not buy or sell a stock because they like the company or its performance. They buy (or sell) a share because they see an opportunity for profit. If they can sell to you at a profit, they will. If you can sell on at a profit, then you will. The markets are profit driven rather than logical. Similarly, fear can drive a market down. Fear of loss is faster than greed for gain usually. Volatility is, therefore, assured as people with little experience play the markets, urged on by the occasional windfall, said Steve Gregory, Managing Partner, Holborn Assets, Dubai.
Another point is that stock volatility doesn't denote the trend, say experts.
Volatility tells you nothing about the trend -whether the share price is going up or down over the long term. It just gives you an idea of how much it could move above or below whatever trend it
has, in the short term, says Cooper of Sarasin-Alpen and Partners.
Importance of beta
It is in this context that, experts say, it is important to know the beta or the volatility of the stock compared to its benchmark. Basically, the beta of a company is the volatility of its share in the market and it may help understand the amount of risk an investor is taking in buying a particular stock, say experts.
However, beta only tells about the past performance of the stock rather than the future performance. "Beta is useful in so far as it goes but it is an imperfect metric. Betas are not constant, they vary over time, so one cannot be certain that a stock that had a low beta in the past will necessarily have a low beta in the future (and vice versa). A good example of this is the pharmaceutical sector, which used to be high beta but became low beta as its growth profile slowed. Nevertheless, beta provides an indication of the risk profile of the stock and so it does have a role in the overall risk management process," says Cooper.
He says growth investors would largely have in their portfolio a beta greater than one. So they can expect their stocks to do well when the market is going up. For value investors the beta is less irrelevant because it will change depending upon economic conditions.
Some experts also add that investors should try to avoid high-beta stocks.
"It might be important [to know the beta before one buys stocks] in the sense that high-beta stocks tend to underperform the general market in direct contradiction to what the capital asset pricing model theory purports. Therefore, investors should try to avoid high-beta stocks," says Karsbol of Saxo Bank.
By Sunil Kumar Singh
© Emirates Business 24/7 2010
