Capitalising on market volatility – two principles
Recent turbulent market conditions may have worked in investors’ favour by offering opportunities to enter or build positions in undervalued shares at attractive levels. But discipline is essential to avoid getting caught up in market emotion (both positive and negative).
By applying two basic principles, investors can make sure they’re in a good position to capitalise on market volatility. These are (1) taking a focused approach, and (2) using proper follow-up buys.
- Take a focused approach
Diversification is an important investment principle. Applied too vigorously, however, it can hinder investment goals. Investing in shares requires thorough research, which takes time. How many companies can you realistically track, investing the time to understand their market strategy, financials and competitive environment? Furthermore, over-diversification leads to reduced expected returns relative to the marginal benefit of reduced risk. While we would never recommend putting all your eggs in one basket, being smart and disciplined in selecting a smaller basket of quality shares greatly increases your chances of achieving better returns.
Disciplined diversification is key
Consider a disciplined approach to diversification – spreading your investment enough to obtain the maximum marginal risk/reward trade-off while being able to keep track of what is happening with each share in your portfolio. Current market conditions highlight the importance of being able to access this information and react rapidly. Owning too many different shares will limit the amount of time and research you are able to invest in each company. This means you’re unable to adequately assess risks and opportunities for each share in your portfolio, which also limits your agility in reacting to new market developments.
Don’t let your portfolio become overexposed to a single share (over 25% exposure) or sector (over 30% exposure). You should also limit the number of counters (instruments) in your portfolio (e.g. 10). This will ensure than you can’t add more shares to your portfolio until you’ve sold out of an existing position.
Ensure your buying decisions are consistent with your philosophy
Your decisions should always be consistent with your investment philosophy, rather than being driven by sentiment and emotion. If you’re a growth investor, for example, your call may be to sell a share when its P/E has fallen below those of its peers, regardless of your personal feelings towards the company. By taking a focused approach, you can optimise your portfolio’s risk profile while reducing mistakes caused by emotional decision-making processes and sentiment.
- Structure follow-up buys sensibly
- Buy into winners
Not every investment decision is going to generate the returns you hope for, but your aim should be to buy more outstanding performers than disappointments. Your goal is not to be right – you’re in it to grow your portfolio value. If you’re buying into a rising market, some shares will rise more than others. You may consider selling the laggards and reallocating the capital to your strongest holdings.
- Take a wait-and-see approach when buying (staggering)
Investing is not an ‘all or nothing’ game, and you don’t have to commit all your available capital in a single transaction. Another strategy is to stagger your buys – watching to see which stocks are performing better and which are lagging.
- Taking profits
The best time to sell a stock is when it’s on the way up – while it’s still doing well and looks like a definite buy to everyone else. It can be difficult to know when a share will correct or reverse, but ideally you want sentiment on your side. Technical analysis can be particularly useful in determining when to enter or take profit on a position.
When it comes to ongoing portfolio management, following a disciplined approach is just as important as it is when initially constructing a portfolio. By putting some parameters in place and ensuring you adhere to your investment philosophy, you are far more likely to achieve your investment objectives than if you follow an unstructured approach.
