How small investors can tide over volatile market times

The sharp drop in the stock markets has left equity investors gasping for breath and fear is back because The benchmark indices lost 9.3% in the 21 trading sessions in August. In the first week itself, the volatility index, which is a measure of the fear prevailing among investors, shot up from 18.78 to 34.88.

Should small investors give in to the fear and move out of the stock markets now? Certainly not. Volatility is inherent to the equity markets and investors must learn to live with it. There are bound to be periods of volatility in the journey of the stock markets. This is clear from the erratic movement of the India VIX index (see chart). Sometimes the volatility gets heightened, but it eventually subsides.

If a 9.3% monthly decline is worrying you, remember that the Nifty had risen by 12.3% in September 2010 and fell by 12% in January this year.

Investors should also note that investment opportunities in the stock markets arise only because of this volatility. Smart investors are able to pick up stocks at bargain levels only when volatility brings down share prices. Likewise, it also offers very good exit opportunities to bargain hunters when it sends the prices spiking up. "The way to make money in stock market is to buy into pessimism and sell into optimism."
There are long-term rewards for equity investors who can get over their 'volatility phobia'. In the past 25 years, the Sensex has witnessed several phases of extreme volatility (see chart). During this period, the stock market had to navigate several corrections (as defined by a fall of more than 10% from the recent peak) and bear markets (as defined by a fall of more than 20% from the recent peak) and the volatility associated with it.
There were three major bear markets, when the benchmark index fell more than 50%. However, any investor who held on to his investment during these turbulent 25 years would have generated a cool annualised return of 14.7%. The message: investors must withstand volatility to create long-term wealth.

Can small investors ride this uncertainty without taking undue risks? Yes, they can but they must learn to ignore the short-term noise. We looked at returns from the Sensex in the past 25 years for different holding periods. The longer the holding period, the lower is volatility, as defined by the difference between the high and low returns (see graphic).