Volatility is considered a measure of risk in investments among the general population and investment professionals, but is it necessarily true? When the market ‘slipped’ in early 2020, many people I know have sold all their stocks and put it all into bonds. Why did they do that?
- Panic
- Lack of knowledge of the companies they owned
- Misunderstanding volatility for risk
The fear that the stocks they owned will go down even further, not knowing the financials of the companies and believing that falling prices are ‘bad’ have all led to the mistake of many investors to sell everything at the bottom. Of course, nobody knew it would be the bottom, but such scenarios can be avoided if an investor implements a system for investing.
Consider the following scenario:
A person come up to you and offers you to buy a farm at a price of $1M. That farm will generate $1M in profit over the next 10 years without a doubt. The next day, the same person again offers you to buy that farm, which is expected to earn $1M in profit over the next 10 years, but at a price of $500k.
Does this drop in price made this investment riskier? Of course not! This drop in price have actually made this investment less risky and more attractive. The same applies to stocks. Stocks are a partial ownership of a business, and if the price of the stock drops significantly, the investor should ask himself if anything in the fundamentals of the business had changed. If nothing had changed and the business is trading at an attractive valuation, that could be an opportunity to buy.
Before buying stocks, an investor should ask himself if he is capable of not panic selling when a stock is down 50% or more. If the answer is ‘no’, that person should not be in the market. If the answer is yes, one should be prepared with a strategy when the market falls.
How to be prepared?
- If you invest in individual stocks, know the companies you own. Sell only when certain predetermined criteria’s are met
- If you invest in index funds, implement a system for buying at a consistent basis regardless of market movement
- Determining how much % of bonds and stocks your portfolio should have at any particular moment will help you stick to your investment system
