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How to invest profitably in volatile markets

July 09, 2010 12:53 IST

Volatility is a recurrent feature of modern markets. The market surges wildly up one day, sharply down the next as sentiment rather valuations becomes its main driver. Making money in such times demands both a cool head and some appropriate tweaking of your normal investing tools and skills.

An investor's style should change in several ways in a turbulent market. First, a good investor becomes a more active decision-maker. In a turbulent market, the reason the market is moving up or down is that something is changing in the current situation or, more probably, in expectations for the future.

As a result, an investor has more of these relationships to understand and reconsider in a period of great flux. For example, the market could move 10 percent or more in just a week, forcing the investor to refigure all those relationships.

Now, this does not mean you trade more often; you're just offered decisions to make more often, and that becomes an extra opportunity and an extra burden.

The second aspect of an investor's approach that changes is the evaluation of the fair value of an asset. In turbulent conditions, it's not quite as clear whether the long-term value has or hasn't changed. For example, in a bear market for an investor like me to buy an asset I think is mispriced, I also have had to decide that its long-term value has not eroded and that the bear market is not correctly pricing the asset.

When you have a turbulent market the turbulence comes from the uncertainty about the future, which means there's uncertainty about what assets are really worth. In effect, the good investor has to raise his or her standard of decision making to be able to confidently say, "I really still believe this company is undervalued or this bond is too cheap." In a turbulent market an investor is less certain of the foundation or fixed point of reference in terms of value.

The third important thing in a turbulent market is to be much more aware of other investors' sentiment in the market. When the market is turbulent and you sense uncertainty, people aren't able to use their traditional processes of discounted cash flow or P/E measures or any other technique they relied upon in the past.

If those models aren't working because the market is moving too quickly, they have to rely on something else, and that's usually sentiment.

Even though I prefer to invest based on economic decision making, a successful investor can't ignore sentiments in a turbulent market, because they probably will be the main driver in the short run. More to the point, if you're on the wrong side of sentiment you can get beaten up fast, even if you're right in the long run.

Becoming much more aware of sentiment, the investor factors it more heavily into his or her decision when the market is moving rapidly in either direction.

Recently this has occurred on both sides. In the technology growth stock boom of 1999 and early-2000 - whether or not you thought those stocks were a good deal - sentiment was clearly on the upside, and you had to consider that. Although it is not really an economic term or a financial factor to consider, in markets that are volatile and moving you have to judge sentiment correctly, or all of your other work could be blown away by that one issue.

Economic versus market risk: What matters?

An investor needs to think about two completely different types of risk. One is market risk, the risk of price volatility. There are quantitative risk measurement tools, as well as measures of volatility such as beta. Another kind of risk is called economic risk.

It's the risk that you misprice your asset badly enough that you will ultimately earn a rate of return that is below the return you expected or needed. I look at risk in these two ways. In the market risk sense, where you are talking about the beta of your stock or the volatility of your stock on a short-term basis, typically the market will pay up for safety. People don't like volatility, and low-volatility stocks generally return less than high. In that case I will have a goal in mind for my portfolio.

If your goal is to be a long-term investor, you can take a certain amount of market risk before you end up just having wild swings. You can actually define the level of market risk you want to take and target that. When we speak about market risk, the risk-return trade-off is what we have all learned: Higher risk generally means higher return.

The interesting part of risk analysis involves economic risk. When considering economic risk, we find the opposite relationship between risk and return - opposite of what we have all learned. With economic risk, we find that higher returns come with lower risk; the investor who finds a low economic risk opportunity will actually make more money and take less risk.

Economic risk refers to the probability that I misvalued this company, and the true rate of return I will earn is lower than I thought. In essence, economic risk is the chance that I didn't actually achieve the return goal I had when I made the investment.

Economic risk can be understood by looking at a simple example. Let's say you have a stock that your research and analysis indicate is worth $100 per share. If you buy it at $80, you have a $20 spread, which represents your return potential and your "margin of safety."

Margin of safety is the measure of economic risk. It defines how much room you have between what you paid for the asset and what it is really worth. The safety factor refers to the idea that even if your analysis and research were slightly off and the stock was truly worth only $90, instead of your estimate of $100, you will still earn a profit of $10. Now consider what happens if you buy the stock for $60.

Now your profit potential has gone up from $20 to $40. In addition, your margin of safety has gone up. Now you have as much as $40 of room for your forecast and valuation to fall and still make a profit on your initial cost. So if you buy the stock at $60 rather than at $80, you have a higher rate of return and a lower risk, because your forecast can be wrong by twice as much and you can still come out ahead.

Typically, when we talk about risk, we are usually talking about market risk - volatile the investment is, how likely I am to lose money in the shorter or intermediate term. But as an investor making decisions, I am actually looking at least as much at economic risk and asking what the odds are that I actually paid too much for this stock and I just don't know it yet.

In that case risk analysis takes on a whole new meaning, because the price you pay has a big influence on the risk you have in the stock, and that's partly why I am a price-conscious, or price-driven, investor. Economic risk goes down if you buy a stock at a bigger discount.

In the long run economic risk is the real risk that counts. If you encounter price volatility over time, but you have correctly figured out the economic value of your stock, it will get there someday, and you will make a profit.

It's critical for clients to understand market risk, but on a true investment basis - ther or not I am going to reach my investment goal - hink economic risk is the more important question.

[Excerpted from the book, Profitable Investing in Volatile Markets. Published by Vision Books.]

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