During volatile times, many investors get spooked and begin to question their investment strategies. This is especially true for novice investors, who can often be tempted to pull out of the market altogether and wait on the sidelines until it seems safe to dive back in. The thing to realize is that market volatility is inevitable. It's the nature of the markets to move up and down over the short-term. Trying to time the market over the short-term is extremely difficult. One solution is to maintain a long-term horizon and ignore the short-term fluctuations. For many investors this is a solid strategy, but even long-term investors should know about volatile markets and the steps that can help them weather this volatility - in this article we'll show you how to do just that.

Tutorial: Managing Risk And Diversification

What Is Volatility?
Volatility is a statistical measure of the tendency of a market or security to rise or fall sharply within a short period of time. Volatility is typically measured by the standard deviation of the return of an investment. Standard deviation is a statistical concept that denotes the amount of variation or deviation that might be expected. For example, it would be possible to see the Standard & Poor's 500 Index (S&P 500) have a standard deviation of about 15%, while a more stable investment, such as a certificate of deposit (CD), will typically have a standard deviation of zero because the return never varies.

Volatile markets are characterized by wide price fluctuations and heavy trading. They often result from an imbalance of trade orders in one direction (for example, all buys and no sells). Some say volatile markets are caused by things like economic releases, company news, a recommendation from a well-known analyst, a popular initial public offering (IPO) or unexpected earnings results. Others blame volatility on day traders, short sellers and institutional investors. One explanation is that investor reactions are caused by psychological forces. This theory flies in the face of efficient market hypothesis (EMH), which states that market prices are correct and adjust to reflect all information. This behavioral approach says that substantial price changes (volatility) result from a collective change of mind by the investing public. It's clear there is no consensus on what causes volatility, however, because volatility exists, investors must develop ways to deal with it. (To read more, see Understanding Volatility Measurements and What causes a significant move in the stock market?)

Staying Invested
One way to deal with volatility is to avoid it altogether. This means staying invested and not paying attention to the short-term fluctuations. Sometimes this can be harder than it sounds - watching your portfolio take a 50% hit in a bear market is more than many can take.

One common misconception about a buy-and-hold strategy is that holding a stock for 20 years is what will make you money. Long-term investing still requires homework because markets are driven by corporate fundamentals. If you find a company with a strong balance sheet and consistent earnings, the short-term fluctuations won't affect the long-term value of the company. In fact, periods of volatility could be a great time to buy if you believe a company is good for the long-term. (To learn more, see Intro To Fundamental Analysis, Reading The Balance Sheet and Advanced Financial Statement Analysis.)

The main argument behind the buy-and-hold strategy is that missing the best few days of the year will cut your return significantly. It varies depending on where you get your data, but the stat will usually sound something like this: "missing the 20 best days could cut your return by more than half." For the most part this is true but, on the other hand, missing the worst 20 days will also increase your portfolio considerably and in some cases, you may want to make trades during volatile market conditions.

What You Need to Know
Investors, especially those that use an online broker, should know that during times of volatility, many firms implement procedures that are designed to decrease the exposure of the firm to extraordinary market risk. For example, in the past, some market-maker firms have temporarily discontinued normal automatic order executions and handled orders manually.

How securities are executed during times of volatile prices and high volume is also different in other ways. The following are some things you should be aware of:

  • Delays - Volatile markets are associated with high volumes of trading, which may cause delays in execution. These high volumes may also cause executions to occur at prices that are significantly different from the market price quoted at the time the order was entered. Investors should ask firms to explain how market makers handle order executions when the market is volatile. With the advent of online trading, we have come to expect quick executions at prices at or near the quotes displayed on our computer screens. Take into account that this isn't always the case. (See Understanding Order Execution.)
  • Website Mayhem - You may have difficulty executing your trades because of the limitations of a system's capacity. In addition, if you are trading online, you may have difficulty accessing your account due to high Internet traffic. For these reasons, most online trading firms offer alternatives like telephone trades, talking to a broker over the phone and faxing your order.
  • Incorrect Quotes - There can be significant price discrepancies between the quote you receive and the price at which your trade is executed. Remember, in a volatile market environment, even real-time quotes may be far behind what is currently happening in the market. In addition, the number of shares available at a certain price (known as the size of a quote) may change rapidly, affecting the likelihood of a quoted price being available to you.

Other Things to Keep in Mind
The type of order you choose is very important when the markets aren't moving in their normal fashion. A market order will always be executed, but in fast markets you might be surprised at what price you get, which can be substantially different from the price that was quoted.

In a volatile market, the limit order - an order placed with a brokerage to buy or sell at a predetermined amount of shares, and at or better than a specified price - is your friend. Limit orders may cost slightly more than market orders but are always a good idea to use because the price at which you will purchase or sell securities is set. On the downside, a limit order does not guarantee you an execution. (For further reading, check out The Basics Of Order Entry and Do stop or limit orders protect against gaps in a stock's price?)

Investors need to be aware of the potential risks during times of volatility. Choosing to stay invested can be a great option if you're confident in your strategy. If, however, you do decide to trade during volatility, be aware of how the market conditions will affect your trade.

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