Opporutnities in Volatility

Reading academic investment literature, one might think that volatility was an enemy to be feared. In fact, volatility is often equated with risk, as though just the fact that prices fluctuate is the same as the risk of losing money. In reality, price fluctuations can present some of the best opportunities. Because different companies (or indices, if you’re into that kind of thing) respond differently to a given set of events, there may be an opportunity to take advantage of price discrepancies.

When the price of various stocks responds differently to a general correction, it’s possible to rebalance a portfolio for capital gains. For example, in late 2008, I watched PIRET (AAR.UN) sink to about 40% of its prior price. Most prices were less severely affected, but this company was a micro-cap and suffered from liquidity issues more than most. I purchased it in November and, when some liquidity returned, I sold it in January. The market was a long way off from recovery, but I moved my money into another similar company, Whiterock REIT (WRK.UN) that hadn’t begun to recover yet. It felt like double-dipping when the second holding also recovered and I used the same pool of money to profit twice.

Trading a range is something that, in theory, works beautifully to magnify gains. I’ve heard people say that they’ve done this, but I imagine it’s a lot harder to manage than it looks. It requires knowing a company well enough to be familiar with the share price history, then identify a range. Buying near the bottom, then selling near the top repeatedly would generate profit, but would also risk riding it down if it falls further than normal, or missing growth if it continues to grow. The S&P 500 is an example of an investible product that’s moved in a range (sort of) over the last decade.

In my own portfolio, I invest for income. I carefully watch the yields during periods of volatility, as we’re seeing now. Recently, Parkland (PKI) has held its value really well, hardly responding to general market movement. However, other companies have fared much worse, such as New Flyer (NFI.UN). By “fared worse”, I mean the share price has fallen by just over 30%. As long as I can feel confident that the dividend is safe, I can sell some PKI and buy more NFI.UN, effectively increasing the yield, and the total monthly income, that I receive from the same amount of capital.

These strategies don’t always work. Sometimes, you can’t do anything, either because the holding that fell is already fully weigthed in the portfolio and buying more would unbalance it, or because the fundamentals don’t warrant an increased investment. If the outlook is very uncertain, it may not be wise to expose more capital to the situation. Investment professionals say, “don’t try to catch falling knives”. A stock may have fallen in value, but there may be a reason. The example of Sino-Forest (which I’m feeling nervous about, given it fell another 50% since I bought it) is a case in point. Just because it’s fallen 75%, doesn’t mean it couldn’t go further. The classic example is Nortel, which fell from over $120 per share to where it was delisted.

If you have a good knowledge of the companies behind the shares you own, or an unwavering faith in the index, rebalancing during volatility can allow you to take advantage of price discrepancies and either generate capital gains or increase portfolio income. Just watch for falling knives and the risk of unbalancing the portfolio by overweighting a company in which you have little confidence.