Download Tips for Investors in Volatile Markets

Tips for Investors in Volatile Markets
Investopedia Staff (Investopedia.com)
During volatile times, many investors get spooked and begin to question their investment
strategy. This is especially true for novice investors, who can often be tempted to pull out
of the market altogether and wait on the sidelines until it seems safe to dive back in.
The thing to realize is that market volatility is inevitable. It's the nature of the markets to
move up and down over the short term. Trying to time the market over the short term is
extremely difficult, some would say impossible. One solution is to maintain a long-term
horizon and ignore the short-term fluctuations. For many investors this is a solid
strategy, but even long-term investors should know about volatile markets and steps
that help investors weather this volatility.
What Is Volatility?
Volatility is a statistical measure of the tendency of a market or security to rise or fall
sharply within a short period of time. Volatility is typically measured by the standard
deviation of the return of an investment. Standard deviation is a statistical concept that
denotes the amount of variation or deviation that might be expected. For example, the
S&P 500 has a standard deviation around 15% while a guaranteed investment like a
bank account has a standard deviation of zero because the return never varies.
Volatile markets are characterized by wide price fluctuations and heavy trading. They
often result from an imbalance of trade orders in one direction (for example, all buys and
no sells). Some say volatile markets are caused by things like company news, a
recommendation from a well known analyst, a popular IPO, or unexpected earnings
results. Others blame volatility on day traders, short sellers, and institutional investors.
One explanation that is gaining steam is that investor reactions are caused by
psychological forces. This theory flies in the face of efficient market hypothesis (EMH),
which says prices are right and reflect all pat information. This behavioral approach says
that substantial price changes (volatility) result from a collective change of mind by the
investing public. It's clear there is no consensus on what causes volatility and probably
never will be. The fact is, though, that volatility exists and investors must develop ways
to deal with it.
Staying Invested
One way to deal with volatility is to avoid it altogether. This means staying invested and
not paying attention to the short-term fluctuations. Sometimes this can be harder than it
sounds--watching your portfolio take a 50% hit in a bear market is more than many can
take.
One common misconception about a buy and hold strategy is that holding a stock for 20
years is what will make you money. Long-term investing still requires homework because
markets will be driven by corporate fundamentals. If you find a company with a strong
balance sheet and consistent earnings, the short-term fluctuations won't affect the longterm value of the company. In fact, periods of volatility could be a great time to buy if
you believe a company is good for the long-term.
The main argument behind keeping invested is that missing the best few days of the year
will cut your return significantly. It varies depending on where you get your data, but the
stat will usually sound something like this: "missing the 20 best days could cut your
return by more than half." For the most part this is true, but, on the other hand, missing
the worst 20 days will also increase your portfolio by quite a bit.
What You Need to Know
Investors, especially those that use an online broker, should know that during times of
volatility many firms implement procedures that are designed to decrease the exposure
of the firm to extraordinary market risk. For example, in the past some market-maker
firms have temporarily discontinued normal automatic order executions and handled
orders manually.
How securities are executed during times of volatile prices and high volume is also
different in other ways. Here are some things you should be aware of:

Delays - Volatile markets are associated with high volumes of trading, which may
cause delays in execution. These high volumes may also cause executions to be at
prices significantly different from the market price quoted at the time the order
was entered. Investors should ask firms to explain how market makers handle
order executions when the market is volatile. With the advent of online trading we
have come to expect quick executions at prices at or near the quotes displayed on
our computer screens. Take into account that this isn't always the case.

Website mayhem - You may have difficulty executing your trades because of
limitations of system capacity. In addition, if you are trading on-line, you may
have difficulty accessing your account due to high Internet traffic. For these
reasons most online trading firms offer alternatives like telephone trades, talking
to a broker over the phone, and faxing your order.

Incorrect quotes -There can be significant price discrepancies between the quote
you receive and the price at which your trade is executed. Remember, in a volatile
market environment, even real-time quotes may be far behind what is currently
happening in the market. In addition, the number of shares available at a certain
price (known as the size of a quote) may change rapidly, affecting the likelihood
of a quoted price being available to you.
Other Things to Keep in Mind
The type of order you choose is very important since the markets aren't moving in their
normal fashion. A market order will always be executed, but in fast markets you might
be surprised at what price you get, which can be substantially different from the price
that was quoted.
In a volatile market, the limit order--an order placed with a brokerage to buy or sell at a
predetermined amount of shares, and at or better than a specified price--is your friend.
Limit orders typically cost slightly more than market orders but are always a good idea to
use because the price at which you will purchase or sell securities is set. On the
downside, a limit order does not guarantee you an execution.
In conclusion, investors need to be aware of the potential risks during times of volatility.
Choosing to stay invested can be a great option if you're confident in your strategy. If,
however, you do decide to trade during volatility, be aware of how the market conditions
will affect your trade.