3 practical steps to profit from market volatility

Most investors hate volatile markets. The best investors exploit volatile markets. Where do you fall? If you witnessed the markets on Aug 24th, you saw extreme price swings not seen since the financial crisis. How is it possible to see huge, high-quality companies trade down 20% and then finish up on the day? The culprits are the massive amount of algorithmic trading and momentum driven investors who try to “get out” before other investors and exacerbate price pressure by adding to the selling. So how can an investor, with little knowledge of the market, end up on the profitable side of market volatility?

Have cash ready to deploy

Nothing is better for capitalizing on volatility than cash reserves ready to be put to work. Not only does cash hold its value during the turmoil, investors don’t have to contemplate what to sell. What’s a good cash level to hold? The best cash amount is a residual level based on the valuations of the equity and fixed income securities in your portfolio and opportunities in the market. 5-20% of your portfolio is a good guide, with more cash as markets get more expensive. Although investors hate getting paid nothing on cash, capturing excess returns during market distress more than compensates for the non-existent yields.

Have a list of quality securities ready to buy 

In times of panic, investors don’t have time to thoroughly research potential investments. The news flow and market movements causes focus to disappear. The solution is to have a portfolio of companies or securities ready to purchase at the right price. All that is missing is a better price, which will occur when volatility strikes. By having this list ready, investors can quickly decide and execute orders without any doubts about the companies they are buying. Best of all, high quality companies get pulled down with the rest of the market. No need to chase highly leveraged, near bankrupt companies. As seen on Aug 24th, companies like GE and Pepsi were pushed down over 20%.

Patience

The biggest problem for investors is the desire to be fully invested at all times because the pain of “doing nothing” is too great. Add in the fact that cash pays nothing today, and you get investors chasing yield all over the market-often in sectors and companies they don’t understand. Great investors have an inordinate amount of patience and conviction in their methodology and knowledge of financial markets. They know crises are hard to predict, but happen in a somewhat regular pattern. Of all three ideas, patience is the most importance. Without it, great ideas and concepts will never be put to work at the right time.

I’ve consistently heard clients talk about market volatility and extreme price moves as if it’s a huge negative. It is if you are unprepared. Great investors see dislocations as an opportunity. Investors have been indoctrinated to worry and pay close attention to short-term volatility, instead of focusing on long-term business returns. Smart investors hope for days like Aug 24th, when unintelligent computer trading and irrational investors rush for the market exit. Those who view volatility as a huge risk instead of opportunity have seriously handicapped their investment portfolio.