Home / Markets / Stock Markets /  Zerodha co-founder explains how retail investors can handle stock market volatility

Information is abundant today and available just a click away. What factors in making differentiating decisions is the source and the credibility, while the markets have been uncertain. One of the key fundamental to live by is mentioned in Principles – a book by Ray Dalio – “Listening to uninformed people is worse than having no answers at all."

While penny stocks have been the choice for most new entrant retail investors which to them is their golden ticket to riches – this approach of ‘quick money’ has led to markets being highly risky avenue for investments. A recent example of this can be seen with a NYSE Listed video game, consumer electronics, and gaming merchandise retailer – GameStop (GME), the stock had no fundamental changes in the business model, financials or leadership – but yet the stock zoomed a staggering 2055% return in 15 trading days.

What was the reason for this turmoil? A group of influential r/WallStreetBets users realized that a staggering amount of GameStop’s shares were being shorted. With so many people—many of them well-established Wall Street institutional players—shorting the company, it could be possible to convince enough contrarian investors (Reddit users) to buy up a bunch of GameStop stock, thereby increasing its value enough to trigger a short squeeze, causing the massive up swing!

Such upswings are usually short lived and prices return to their true valuations soon - these price movements can be dangerous with the market regulations to freeze trading upon exceeding the upper and lower limits causing high liquidity risk.

While the global markets dipped in March 2020 – there was great deal of panic but ace investors flocked to markets to increase their exposure to ‘crème de la crème’ companies to their portfolios,top global investors like Warren Buffet and Gates Foundation added stocks like Amazon (AMZN), Apple (AAPL), Moody's Corp. (MCO), Waste Management Inc (WM) etc. While the markets buzzed about companies like ‘GameStop’ and ‘AMC Entertainment’

Another key differentiator between the niche investors and the masses is that price and value are different. As an investor, our job is to find the disconnect between the two. It is always important to focus on the inherent fundamentals and to avoid the most of the noise.

Although increasing retail participation is a good sign of growth portraying that the citizens are willing to invest rather than take risk adverse measure such as savings schemes – we need more initiatives to promote financial literacy and handle volatility.

The fundamental rules to handle volatility for retail investors would include:

● Realistic and Appropriate Risk to Reward Ratios – The standard R:R is 1:2 which in the long run helps retail investors have more green days than red.

● Position sizing - Position sizing is all about answering how much capital you will expose to a particular trade given that you have ‘x’ amount of trading capital. One classic position sizing strategy which most people employ is the standard 5% rule. The 5% rule does not permit you to risk more than 5% of the capital on a given trade. The percentage can differ based on the individuals risk taking ability but should exceed 5% and stresses on the strict Stop-Loss.

● Avoiding leverage – Leverage is a double-edged sword, it does help retail traders to magnify their capital but also can be a key reason for capital erosion.

● Avoid penny stocks – Penny stocks can be extremely volatile and have been proven to erode investor wealth.

● Diversification – It is one the key principles of wealth creation, diversification across companies, sectors and even asset classes (we have seen how effect a gold hedge can work in 2020).

● Avoiding unsolicited tips/SMS – With increasing retail participation there has been a great deal of scams around stock tips/calls, these should be avoided as they may not be under appropriate regulation.

Finally, with the Indian Union Budget around the corner the market frenzy is expected to increase quite significant based on historical references – in case of favorable markets movements it would be interesting to watch if India finds a ‘GameStop’ or a ‘Tesla’ out of the budget frenzy!

The writer is co-founder and CIO, True Beacon and Zerodha

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