Understanding Market Volatility & Risk Management Strategies

Hello everyone! We're opening a new chapter at Pave Academy today. We're exploring the ups and downs—quite literally—of market volatility and how to manage risks. Trust me, if you ask any successful investor to give one piece of advice to anyone thinking about getting serious about the financial markets, they will tell you one thing–success is contingent on risk management, and risk management alone.

You can have the most brilliant market insights, but if you haven’t mastered risk management, you will likely bed is satisfied with your investment results over time. While investing is an exciting prospect, the reality is that you can lose some, if not all, of your investment capital. The name of the game is to set yourself up to cushion yourself against the bad times that inevitably arrive.

How to approach the topic of risk management starts with market volatility: how to measure it and how to manage it. In simple terms, it's the degree to which the market fluctuates daily. Now, let's get something straight–volatility can be defined in three ways–

1. Absolute volatility,
2. Equity-specific index volatility or market volatility
3. Your portfolio’s volatility  

It sounds complicated, and the calculations we do beneath the surface of the Pave app are incredibly complex. Still, we can explain the concept of volatility simply.

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Absolute Volatility

Absolute volatility is measured as the sum of all the up and down movements in asset prices. To be exact, we use the percentage increase or decrease in the daily price rather than the actual daily close, but for simplicity’s sake, let’s think only in price terms rather than returns for now. We ignore the second-to-second fluctuations and just take the daily closing price changes and calculate the standard deviation. Standard deviation measures how far off each closing price is from its average. If an asset, a portfolio, or a stock index has 0% annual volatility (a standard deviation of zero), every daily closing price for that year was precisely at the year's average. Suppose there are massive swings for a particular asset every day. In that case, the volatility measure is exceptionally high when you sum up all the significant gaps between all the daily closes over a year and compare it to the average price for the year.

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Market Volatility

Market volatility is calculated the same way as absolute volatility, but you take the daily close of the entire stock market against its average price to calculate its standard deviation. Because the“ stock market” is composed of many stocks, its volatility reflects the sum of all those parts. Remember this–while most professionals measure market volatility as the standard deviation of the S&P 500, the “market” should be the relevant index to your risk tolerance. That means “the market” should be the benchmark that reflects your investment style. Market volatility is the center of the universe, and measuring your portfolio’s risk is always about the market’s volatility. When we talk about the volatility of individual stocks or portfolios, we compare them to this baseline.

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Portfolio Volatility

Portfolio volatility is measured using the same approach. The important thing to know is that you can make changes to your portfolio, and based on the characteristics of the stocks that are added or deleted, it can make your portfolio more or less risky–that is, the standard deviation can increase or decrease.

An other key element to the risk management process is that while the mix of stocks in your portfolio can be more volatile or less volatile, you also need to see how its movements relate to the market’s price changes. This is often measured using a metric called "beta."

Most investors use the S&P 500 as a yardstick for the market, and its beta is 1.0; your stocks and your portfolio are measured against a beta of 1. Suppose your portfolio makes 21% when the S&P is up 20% over the same period. In that case, it is a good result if your portfolio beta is a conservative .9. However, you're taking much bigger risks to get that extra one percent if your portfolio beta is 1.5. That means you're shouldering 50% more risk just to get a 5% higher return (21% is 5% better than20%). That's like betting a lot more to win, just a little extra.

So, what's the key to managing this kind of risk? It isn't just about diversification for the sake of having a "mixed bag" of assets. The actual strategy is to diversify into assets that behave differently from each other—assets that have low correlations. This means that when one asset zigs, the other zags.

For instance, during the 2008 economic downturn, many people who diversified by including gold in their portfolios found some relief. Why? Because gold often moves in the opposite direction to stocks and bonds. This is an excellent example of how having uncorrelated assets can mitigate risk.

The aim is to construct a more efficient portfolio that delivers comparable or better returns for the same or lower risk than the market. That way, you're better positioned to weather the storms of market volatility over the long term.

Remember, the goal isn't to altogether avoid risk—that's impossible. The goal is to understand and manage it effectively.

Hedging Strategies & Techniques

Hello, everyone, and welcome back to our journey through the intriguing world of finance! In this topic, we're diving deep into hedging strategies. Now, hedging is like insurance for your investments. You're essentially taking steps to protect yourself against potential financial losses.

Now, why is hedging important? It can help safeguard your portfolio from the financial 'storms' that can come from market volatility. It cannot entirely shield you–the only way to do that is to be completely in riskless securities–but it can help offset exposures that represent excessive risks that are not consistent with a prudent, long-term investment approach.

The catchphrase is limiting your financial losses, not eliminating them. Let's explore some key hedging strategies.

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Diversification& Asset Allocation

Diversification

This is your investment world's 'don't put all your eggs in one basket' approach. You shouldn't put a disproportionate amount of your money into a single type of investment. Apple stock might be doing great today, but what if there is a massive tech crash tomorrow? If you're also invested in other sectors like healthcare or utilities, the hit to your tech stocks won't wipe out your entire portfolio.

Asset Allocation

This is a more sophisticated form of diversification. You're diversifying across different companies or industries and assets like stocks, bonds, and perhaps even commodities like gold.

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Hedging Techniques

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Here, we get into some specific financial instruments used for hedging. One popular technique is using options. Let's say you own shares of a tech company that is performing well, but you're worried about a future downturn. You could buy an 'option' to sell those shares at a predetermined price. So even if the stock plummets, you're protected because you can still sell at the higher, predetermined price.

Put options give you the right to sell a stock at a specific price within a certain time, regardless of how low the actual market price goes. For example, if you're worried that the value of a particular stock you own might plummet, you can buy a put option as a safety net.

Like any insurance, there is a cost–in fact, the price of an option is called a premium, similar to an insurance premium. It is also a decaying asset, so if the market does not move down, that option’s price will eventually go to zero. There are different option contract lengths before their expiration, and of course, the longer the contract term, the higher the price.

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Consider a stop-loss order as your financial seat belt. Just like a seatbelt mitigates the impact of a crash, a stop-loss order can limit your losses when a stock price drops. You set a predetermined price—say you bought a stock at $50, you could place a stop-loss order at $45.If the price drops to that level, the stock is automatically sold, limiting your downside. Be warned–sometimes a stock price can gap down below your stop loss, and you can end up selling much lower than $45, sustaining a more significant loss than anticipated, but at least you are out of that exposure.

Both stop-loss orders and put options are about managing risk. And managing risk is what smart investing is all about. Just as you would wear a helmet when biking, these financial safeguards help you practice 'safe investing.'

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Remember that the hedging technique should align with your investment goals and risk tolerance.

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To sum it up, hedging is all about preparing for the 'what-ifs' of the financial markets. The right mix of diversification, asset allocation, and hedging techniques can go a long way in safeguarding your investments against unforeseen events. So go ahead, put on your financial 'hardhat,' and build a resilient portfolio for the long run.

Wrapping Up Risk Management

Hello, and thanks for staying tuned! As we wrap up this module, we will discuss some equally important but often overlooked aspects of investing: understanding your risk tolerance, being aware of behavioral biases, and having a contingency plan.

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Risk Tolerance Assessment

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Knowing how much risk you can tolerate is fundamental to making any investment decision. Too much risk, and you might lose sleep. Too little risk and your money might not grow as you'd like. You can read books and take quizzes to figure this out or simplify the process using Pave's built-in feature that helps assess your risk tolerance and recommends an investment strategy accordingly.

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Behavioral Biases

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Investing isn't just about numbers; it's also about understanding human behavior, especially your own. Ever heard of FOMO, the Fear Of Missing Out? It's a common emotional pitfall that can cause you to jump into a high-risk asset just because everyone else is. On the flip side, there's panic selling—unloading your investments when the market takes a dip, which is often a rash decision fuelled by fear. Relying on analytical tools helps contain these emotional lurches, but you must watch yourself when these emotions arise because logic and good judgment will serve you over the long run.

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Contingency Plans

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Let's not forget markets are unpredictable. Always have a Plan B, which could mean setting aside a cash reserve for emergencies, diversifying your investments across different sectors, or having stop-loss orders to limit potential losses. A contingency plan prepares you for the worst and gives you the confidence to invest more wisely.

And there you have it! Understanding your risk tolerance, being mindful of behavioral biases, and having a solid contingency plan is crucial for surviving and thriving in the volatile world of investments. Thank you for joining us, and we look forward to seeing you in the next module!