Market volatility, much like we have witnessed recently, is generally characterized by rapid and substantial price fluctuations, and is often perceived as a source of risk and anxiety for investors.
However, a deeper analysis reveals that volatility can also provide significant opportunities for those who are prepared to navigate its inherent uncertainties and focus on the underlying fundamentals of the pool of options.
Rather than viewing volatility as a purely negative phenomenon, astute investors recognize its potential to create advantageous entry points and generate alpha within their portfolios.
One of the primary ways that volatility creates opportunities is through the mispricing of assets. During periods of heightened market anxiety, driven by factors such as economic uncertainty, geopolitical events, unexpected corporate news, and/or political uncertainties, investors may react emotionally, leading to indiscriminate selling.
This situation may lead to fundamentally sound companies trading at perceived undervaluation, creating a window for investors to acquire quality assets at relatively discounted prices.
Conversely, periods of excessive optimism can inflate asset prices to a point where there are opportunities for investors to trim their positions and lock in some of the gains.
Warren Buffett said it best: “Be greedy when others are fearful and be fearful when others are greedy.”
Volatility often leads to increased dispersion of returns across different asset classes and sectors. This creates opportunities for active managers to outperform passive benchmarks by identifying and exploiting market inefficiencies.
In volatile markets, the ability to conduct thorough fundamental analysis and make informed investment decisions becomes paramount. It is by focusing on the underlying soundness of the investment options and making strategic investment decisions that one may be able to effectively navigate the turbulence and potentially generate significant alpha.
As part of our 5-step due diligence process, we work to determine the cause(s) of volatility while analyzing potential areas of dislocation that may provide attractive entry/addition points.
However, it is crucial to acknowledge that capitalizing on volatility requires a disciplined and strategic approach.
As advisors, it is important that we educate our clients with a strong understanding of their risk tolerance, a long-term investment horizon, and a well-defined investment plan. Emotional decision-making, driven by fear or greed, can lead to costly mistakes.
It is important during times of increased volatility to adhere to the plan that you initially developed with your advisor and to reassess your risk-tolerance level to determine if there is a need to de-risk your overall holdings.
It is also important to incorporate diversification into the overall strategy to avoid a significant impact by any small group of concentrated holdings.
As stated previously, thorough due diligence is critical during periods of heightened volatility as it is imperative to analyze the underlying fundamentals of potential investments and avoid being swayed by short-term market noise.
Understanding the long- and short-term financials, profitability metrics, earnings quality (ROE, ROIC, etc.), Free Cash Flow generation, as well as other metrics are a critical component that is vital in determining whether a company is undervalued or overvalued.
Market volatility is an inherent risk in the investment world, but it does not need to be viewed as solely a negative. In fact, we could argue that periods of increased volatility provide us with greater potential opportunities to enhance our overall strategies.
By understanding the mechanisms through which volatility creates mispricing and potentially enhances investment strategies, investors may be able to transform periods of uncertainty into periods of significant potential gains.
A disciplined approach, coupled with a long-term perspective and rigorous due diligence, is essential for navigating volatile markets and capitalizing on the opportunities they present.
This is all part of the holistic strategy to provide you with Financial Peace of Mind. It is during the periods of volatility where it pays to have a team that you know is looking out for your best interest.
