3 POINTS TO UNDERSTAND MARKET VOLATILITY

Yes, it is true. The market has delivered over 15% annualised returns since inception. Just for the records, the BSE Sensex was taken as 100 on the 1st of April 1979. Till the day of writing this article, the Sensex has delivered an annualised returns of 16.07%, not considering dividends. Unfortunately, most investors don’t get anywhere near that return out of their equity investments. While investor behaviour is to be largely blamed for this, the root cause of all is the volatility or uncertainty of the market returns.

Understanding the volatility, accepting the uncertainty and risks is the first step of qualification for any successful investor. One needs to be comfortable and also understand that you are in control to make use of this volatility or react to it. This is where the real investors get separated from those learning the ropes. Many other factors determine your returns including lack of a proper plan, behavioural mistakes, wrong asset allocation, lack of patience and so on. However, we will restrict our discussion to the study of this volatility in this article.

Let us first take a closer look at the volatility over short periods. We are using the BSE Sensex index closing prices since the year 1980 giving us 40 years of observations. What we have done is grouped the returns in ranges of 10% and 20% for monthly and yearly returns respectively. We have showcased the number of observations (periods) as count and given the average returns for these observations.

TABLE 1: OBSERVATIONS OF MONTHLY RETURNS

Showing Month / Year [% absolute returns] for only the most volatile month.

As we can see, there are a total of 488 monthly observations available to us. In these 57.8% of times we have seen positive equity returns. The average returns for the positive months is also greater at 6.43% than the negative months at (-) 5.10% returns. Statistically, the positive bias has given an 'average' monthly return of 1.48% for the till date since 1980. The range of maximum and minimum one month returns (-24% and 42%) was observed during the last financial crisis of 2008 and the bull run of Harshad Mehta scam.

TABLE 2: OBSERVATIONS OF YEARLY RETURNS

Actual Year [% absolute returns]

Since the count of observations are less, we have showcased actual years here. As we can see, there are a total of 40 yearly observations available to us. With a slight increase in the horizon, the positive observations are now up at 70% with 28 years giving positive returns vs 11 negative years. The average returns for the positive years is also greater at 32.44% than the negative years at (-) 16.44% returns. The average yearly returns till date stand at 21.18%. More interestingly, the range of returns is very extreme – from negative of 52% to a positive of about 73% post year 2000.

WHAT HAPPENS IN LONGER DURATIONS ?

It is apparently very clear from the observations above that the markets tend to be very volatile in shorter horizons. Even an increase from monthly to yearly clearly reduces the volatility and the probability for positive returns. However, since equities are long-term assets, such shorter horizons only indicate the extreme returns which can happen in one year for which we have be prepared for. This is something, we believe, everyone has clearly experienced in the present pandemic too.

Below is a table showcasing summarised insights over different holding periods /horizons. Please spend a couple of minutes to understand this table.

You will realise a lot of things very clearly from the table above. To avoid repetition of data above, lets jump directly to the learnings ...

• The extreme returns are observed in shorter investment horizons. In other words, markets are more volatile over shorter periods.
• The probability of making losses / negative returns is higher for shorter periods and lower for longer investment horizons. Historical records show that the probability for making losses is also zero if the investment horizon is 10 years and above.
• Note that for even long-term horizons, the minimum returns can be in single digits even though the probability is less.
• Although this volatility can present significant investment risk, when correctly harnessed, it can also generate solid returns for shrewd investors.

In short, returns become more less extreme, less volatile and more predictable, consistent as we increase investment horizons. Please note that the periods considered are calendar periods and strictly speaking years begin on 1st January but the levels are random in nature.

A DEEP DIVE

Is volatility good? Wise investors will always say Yes. Why? Because volatility gives rise to opportunities to investors to make abnormal returns. It opens up doors to enter and/or exit markets as per your needs. The real benefits of say SIP will be truly realised if the markets are volatile. Unless there is no personal need for capital, a wise investor will always pray for the market to be in bear phase or at lows so that he can add to his positions.

We also observe that the markets are generally bullish in nature and don’t like to remain at bottoms or in bear phases for long. However, the chances of attractive returns reduces as the markets deliver higher returns. However, we have found that predicting the markets is futile as market can continue to stay and rise even from higher levels. Thus, it becomes really tough to predict future trends. Trying to time markets has proven to be a damaging strategy for many investors. Instead, bold, decisive and timely actions taken in staggered manner as markets move into extremes have proven to be a more reliable strategy.

As long as term observations prove, making money in the markets is relatively easy and requires no IQ. In fact, the market wants you to profit. What is required though is common sense and patience. Investors prevent themselves from participating in the returns by going out of their way to make mistakes and being extra smart. The easiest way to manage your entire portfolio with market cycles is by following a fixed or a dynamic asset allocation strategy. For fresh investments, disciplined SIPs is whether proof. We would urge the readers to talk to their Financial Planners / Financial Advisors on how following an asset allocation approach can benefit them over long term.