Take the diversification route to beat market volatility

The Indian equity markets have historically been a rich source of returns. However, these returns have been marked by significant volatility. In fact, the volatility of the Indian market at above 26% is one of the highest in the world.

Though the long-term CAGR of the market is 15.60%, there have been specific points in time when the market returned 1.25% pa for a 10-year period as well as 19.98% pa for another 10-year period. Hence, managing this volatility is the key to investing in the Indian equity markets.

So how can one go about doing this? One of the biggest impacts of volatility is that it increases the entry-point and exit-point risks in investing. The simplest way of tackling this risk is to invest through the systematic investment plan (SIP) route. By investing in the market at regular periods of time, irrespective of the levels, we can achieve cost averaging and also participate in the longterm upward trend of the Indian markets.

If you are investing directly through stocks, then it is better to stick to the stable large-cap blue-chip companies during volatile times. These companies have proven track record and, hence, have higher probability of wading through tough times in case of turmoil.

Let's also look at another problem. In case you have a lump sum to invest and cannot go through the SIP route, but are worried about the entrypoint risk due to volatility, you have a couple of options. First, you can take advantage of the traditional free-lunch of investing - diversification.

Diversification across asset classes like debt, gold, other commodities, etc, help in reducing volatility of the overall portfolio. What works to the advantage of the investor is the low correlation between some asset classes. For example, the equity markets fell by more than 50% in 2008, whereas some debt funds returned 27% in the same year. Commodities like gold have very low correlation with both debt and equities.

However, a diversified portfolio may not get the best return with respect to the other asset classes but it will also never be the worst performer. One needs to understand this while investing. Second, there are now newer vehicles for investing offered by fund houses, which focus on reducing the volatility of investments, without the investor having to worry about diversification, asset allocation, etc.

These funds use different methods to manage volatility. Some funds like the Edelweiss Absolute Return Fund use multiple uncorrelated strategies like arbitrage and corporate events investing to reduce the risk level of the fund. In addition, dynamically managing exposure using quantitative hedging algorithms reduces the heart attacks that investors go through periods like 2008.

Other funds like dynamic P/E funds manage the asset allocation between debt and equity on the basis of triggers like market P/E levels and drawdowns. To conclude, there are various options available to an investor based on his risk appetite and his propensity to understand the various options available to him.

However, the best piece of insurance one has against volatility is the advice of a sanguine financial advisor, who will recommend the right allocations and strategies based on his insights into your portfolio.

(Vikaas M Sachdeva, Chief Executive Officer, Edelweiss Asset Management)

Source: Economic Times

Thanks and Regards,
Sanchari Sinha,
Intern at DENIP Consultants Pvt. Ltd.