Is the recent stock market volatility unusual?

Before I answer that question, let me try and explain what volatility in the stock market really means. To the ordinary investor, volatility may mean sudden and unexpected changes in a stock’s price (or an index level).

But aren’t fluctuations in stock prices and index levels the norm rather than the exception? That’s an easier question to answer. Yes, stock prices and index levels do fluctuate all the time. But some times, the fluctuations are tolerable and ‘normal’. Those are periods of low volatility, which are conducive for trading and investments.

At other times, there are extraordinary and nerve-wracking fluctuations in stock prices and index levels that send traders and investors scurrying for cover. Such periods of high volatility increases risk and decreases returns.

For the mathematically inclined, volatility is a statistical measure of the uncertainty or risk associated with changes in a stock’s price (or an index level). It can be measured by using the standard deviation or variance (i.e. two standard deviations) of the returns from a stock or index.

A measure of the overall volatility of a stock’s return benchmarked against an index is called ‘Beta’. A Beta value of 1.0 means the stock’s return is the same as that of the index. In other words, if the index gains 100%, the stock will gain 100%. A Beta value of 1.5 means a stock will gain 50% more than the index during bull periods, but lose 50% more during bear periods; a value of 0.8 means the stock will gain 20% less than the index in a bull market, and lose 20% less in a bear market. The higher the Beta value, the more volatile the stock.

For the technically inclined, the Nifty VIX chart indicates the implied volatility (IV) of a basket of Nifty put and call options. A high VIX level (above 30) indicates high volatility; a low VIX value (below 20) indicates low volatility. Typically, when the VIX rises, the Nifty falls. The VIX can be used as a contra-indicator. Low values give an opportunity to sell, and high values provide opportunities to buy.

What causes high volatility? Unexpected changes - in interest rates (repo, reverse repo) or oil prices; a war or terrorist attack or earthquake; a change of government - can lead to wide fluctuations in stock prices and index levels.

What can small investors do? Understand this simple thumb-rule. Volatility declines when stock markets rise, and increases when stock markets fall. In a bear market – like now – high volatility is not unusual.

That is one reason why small investors may be better off staying away instead of trying to make a few bucks on counter-trend rallies; and avoid averaging-down during bear markets.

That was the long answer. The short answer to the question is: No.

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What is causing the volatility in the Sensex?

How many shares of each company should I buy?

A common question vexing many small investors is how many shares of each company to buy. A young investor friend did quite a detailed analysis of a particular company, and took some inputs from me to fine-tune his analysis process.

After a few iterations to arrive at a proper valuation, he decided that the current price had enough ‘Margin of Safety’ and decided to buy the shares of the company. How many shares did he buy? 100. Nothing wrong with that. Small investors can’t always spare a lot of cash.

What happened next? Within a short time, the stock spurted on large volumes and doubled in price. My friend was left ruing the fact that he didn’t buy more shares even though he had spare cash. Shortly thereafter, the company announced a bonus issue, and the stock spurted even higher.

In spite of doing due diligence, a big money-making opportunity was lost because a sufficient quantity of shares were not purchased to start with. Such opportunities don’t come often. So, how do you decide what is a ‘sufficient quantity’?

In last Tueday’s post: How many stocks should I buy?, I had outlined how a Rs 5 lakh portfolio can be allocated to large caps, mid caps and small caps. The suggestion was: 8 large caps worth Rs 50,000 each, plus two mid caps and two small caps worth Rs 25,000 each.

While the money allocation to each category of stocks would automatically limit how many shares of each company you can buy, it won’t eliminate the risk factor. Different investors have different risk tolerance levels, and that should be built into the allocation.

Here is a simple example. Suppose you decide that the maximum loss you can afford in the large cap stocks is 5%, and 10% in the mid and small cap stocks. Your large cap allocation is Rs 50,000 to each of 8 companies. Your mid and small cap allocation is Rs 25,000 to each of 4 companies. A 5% loss in the large caps and a 10% loss in the mid and small caps would limit the loss to Rs 2500 per stock.

(If all your picks fail to perform and hit the respective stop-loss levels, your total loss will be limited to Rs 30,000; i.e. 6% of your Rs 5 Lakh portfolio.)

If you decide to buy a large cap with a current price of Rs 100, you can buy 500 shares with a Rs 5 stop-loss to ensure that you limit your loss to Rs 2500. What if a mid cap is trading at Rs 100? Should you buy 500 shares in that case?

Since mid caps tend to fluctuate more, you had chosen a 10% loss as your limit. That would mean buying a Rs 100 stock with a Rs 10 stop-loss. Buying 500 shares may incur a loss of Rs 5000 if your stop-loss is hit. So, you need to buy only 250 shares with a Rs 10 stop-loss.

The example is simplistic to make a point. You need to adjust stop-loss levels for each stock that you buy according to your comfort level and the beta value (i.e. the amount by which a stock fluctuates with respect to an index) of each stock.