How might I profit from stock market volatility?

Some investors are scared by bouts of stock market volatility. Our writer explains why he sees them as an opportunity to build his portfolio.

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It has been a lively few years in the stock market – and there is no end in sight. The combination of a sluggish economy, high inflation and a huge US bank run last week means that we could see more stock market volatility in coming weeks.

As an investor that can seem scary, especially if the value of one’s portfolio falls sharply. But such volatility is part and parcel of being a long-term investor. In fact, I think it can offer me some potentially rewarding opportunities.

Look to the cause

When a share price falls during a period of stock market volatility, it is often for one (or both) of two reasons.

The first reason is that stock prices are falling because businesses are expected to do worse, meaning they are worth less than before. An example of this in my opinion is the 35% decline in the Fevertree Drinks share price seen over the past year.

Inflation threatens to eat into profit margins while cash-strapped consumers may trade down from fancy fizzy drinks. That combination of potentially lower demand and higher costs could hit Fevertree at both the top and bottom lines. Investors have marked down the shares, even though for now at least revenue growth remains strong.

But another reason share prices fall during a period of market volatility is that a general sense of investor panic sets in. That can push down shares in businesses that are likely to keep performing as they did beforehand.

For example, at the onset of the pandemic, National Grid shares fell 18% in one month between February and March 2020.

Yet were the business prospects of an energy distribution monopoly affected that much by the prospect of a pandemic? I do not think so. If I had bought at that point in March 2020, my shares would now be worth 21% more than I paid for them. The dividend yield is 4.9% — but if I had bought then at a lower share price, my yield would be higher.

Buying value on sale

The first sort of situation can lead investors to value traps. Shares may look cheap compared to their historical prices. But a change in the underlying business outlook can mean a company’s earnings are set to become lower, justifying a lighter valuation. What looks like a bargain can turn out to be the opposite.

But the second scenario strikes me as a rich place in which to fish for real bargains. Cheapness is not just about price – it is also about value. If I can purchase shares in a quality company for much less than they are worth, buying them to hold for the long term could help me profit from stock market volatility.

Getting ready

The challenge is that such volatility can be short-lived.

Waiting for the next stock market correction or crash before deciding what bargains I might want to buy could mean prices have recovered before I have made up my mind!

Instead, I think the time to act is now.

By drawing up a shopping list of great companies I would like to own in my portfolio if only I could buy their shares cheaply enough, I will be ready to pounce when the stock market wobbles again.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

C Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended Fevertree Drinks Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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