The forex market is a volatile place. Everyday issues around the world involving geopolitical crises, economic and business news, and natural disasters, drive the markets up and down causing market volatility.
Most of the time, investors take the ups and downs in their stride. But, consistent decline in the markets can unnerve even the best of them, and cause them to make decisions that affect their long-term portfolios. The key is to learning when and how to take advantage of this volatility.
What is Market Volatility?
Volatility can be defined as the tendency of a currency pair, stock or a market to rise and fall sharply, within a short period of time. Wide price fluctuations and heavy trading are the usual characteristics of a volatile market. There are lots of factors that can cause volatility. Economic releases, unexpected wars, popular IPOs and company news are some of the common reasons. Day traders, short sellers and institutional investors can also cause volatility. Market reactions are governed by investor psychology. A common reaction (buying or selling a stock), by many investors can therefore cause volatility too.
There is no single reason for market volatility, but it is inevitable in stock markets and investors need to learn to deal with it.
A Good Thing for Short-Term Traders
Market volatility is good for short-term traders like day traders or intra-day traders. Unlike a long-term investor, who is satisfied with a consistent increase in share price every year, the outlook for short term traders is quite different. They think it is better to take some risk in order to gain the same yield in a week, rather than waiting for a year.
A short-term trader analyses charts and information available, to spot a low trend and buy cheap. Then they sell the same equity a few days later when the price surges. This is the reason why they mostly invest in start-ups and small-cap stocks. They also invest in volatile industries, such as technology and biotech.
Long-Term Investors – Tackling Market Volatility
Long-term traders take steps to minimise the impact of volatility on their stocks. Diversifying the portfolio is one way of doing so. Along with diversification, asset allocation is also an important tool. When stocks go into decline, it is highly unlikely that all types of investments, including currency pairs, bonds and cash equivalents, will perform poorly. Understanding the different types of risks, such as market risk, inflation risk and retirement risk, is also essential before diversification and allocation.
Can Volatility Be Good for Long-Term Investors?
The ‘Buy and Hold’ strategy is no guarantee of gaining profits after 20 to 30 years. Only those companies that have a strong balance sheet and give consistent earnings are worthy of falling into this category. It requires a fair amount of research and discipline to keep track of company updates.
In fact, short-term fluctuations don’t affect the long-term stock values of these companies. In the past, ‘Buy and Hold’ investors have had the double benefit of enjoying an increase in equity on a year-to-year basis and quarterly dividends as well. But now, most of these companies offer minimal dividend or no dividend at all, in exchange for stock buybacks.
Volatility is good in such cases, since investors might get higher-than-expected returns.