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Volatility

Volatility has always been, and will always be, a fundamental part of investing. Without volatile markets, the opportunity for profit would not exist. The problem is that everyone loves upside volatility but hates downside volatility. Unfortunately, one cannot exist without the other.

To most investors, volatility means the risk of losing part of the principal invested in a stock. To professional investors and academics, volatility means the standard deviation of returns, or how much a stock's return can be expected to vary from the average return. Let's stick with the definition that most investors use instead of the academic definition. The best assumption to make when initially buying any stock is that the stock will fall in price at some time during the period you expect to hold it. It could go straight down immediately after purchase or it may not go down for several months. But assume that it will go down sometime. When it does, will you sell the stock, buy more shares, or just sit there and watch it fluctuate? This is best answered before the original purchase is made rather than at the time the stock first falls below your purchase price. The key is to anticipate your response to the drop in price and be prepared to take action without getting caught up in the emotions of the moment. Doing so helps you avoid panic selling and missed opportunities.

A Diversified Portfolio

In preparation for volatility, investment professionals recommend that investors develop diversified portfolios to reduce the potential impact of stocks from a single industry falling at the same time. In other words, if you are going to invest in high-tech, "new-economy" stocks, include them as part of a portfolio that contains other, more stable stocks.

A well-diversified portfolio contains many stocks in different industries. That does not mean that you should buy mainframe computer manufacturers, semiconductor companies, software companies, Web retailers, etc. Even though each of those may be considered a different industry, they are merely branches of the same tree. When lightening strikes the tree, all the branches may fall. Include one or two stocks from these industries with stocks from financial, energy, healthcare, retail and other unrelated industries in a portfolio. Then, when downside volatility strikes one industry, the impact to the entire portfolio may not even be noticeable if the other stocks are rising in price.

Assume that, as part of a diversified portfolio, you own several "new-economy" stocks that have fallen in price. If you believe in those companies for the long-term, you should consider buying more shares while the price is low. Most investors want to see stock prices continually rising. What they should want are falling prices when they decide that they want to own a stock. If the stock was a good value at the higher price, it is a better value at the lower price (considering the assumptions used in estimating its intrinsic value still hold). The lower price will allow an investor to buy more shares and further benefit from higher potential appreciation should the stock reach its expected intrinsic value.

On the other hand, you may have made a mistake. The best and brightest investment professionals make mistakes in spite of their extensive financial statement analysis, conversations with company management and years of experience as stock pickers. Decide, before you buy, under what conditions you will sell if the stock price falls. Generally, a falling price without an underlying change in business fundamentals is not a good reason to sell. If the price falls as a consequence of a change in the expected growth rate of sales or earnings, this may be a sufficient reason to sell. Establish some parameters before you buy that can provide the reasons for you to sell the stock.

Volatility is a necessary ingredient of stock market investing. It is an investor's friend when stock prices rise; it hurts the stockowner tremendously when stock prices fall. Take some time before making an investment to anticipate your response should the stock you buy fall immediately after purchase or should it fall after an increase in price. Know some of the options available to you so that you can make an informed decision with a minimal amount of emotion. This will make stock investing a much more enjoyable and profitable experience.

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The information contained herein is considered accurate at the time of posting. CIBC and CIBC World Markets Inc. reserve the right to change any of it without prior notice. It is for general information purposes only.

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