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Fear and Greed – not a strategy

Stick with your long-term asset allocation

Shruti Jain, Arihant Capital Markets
An article sourced from: Times of India, published 18th Dec 2007

"The key to surviving in a rapidly changing market environment is to identify your final destination, chart a course to reach it, and then stay the course. Riding out the storms is often the hardest thing to do, but it is key to reaching your long-term goals". Peter Lynch.

We are seeing a sustained northward rise in our equity markets after the US Federal Reserve (Fed) cut the key short-term rate on 18th September’07. The Fed cut came in as positive news not for just Indian equity markets, but other emerging markets soared as well. Many market participants expected the Fed to cut the rate by 25 basis points, but the Federal Reserve reduced it by 50 basis points, which came in as a positive surprise.

Soaring Markets Sensex High

Our economic fundamentals still remain healthy and there is no change in the country’s economic outlook. Finance Minister’s positive outlook on the FY08 GDP growth reaffirms the good health of our economy. Increased liquidity globally is expected to drive the emerging markets to higher valuation and we can see this trend in our market as well.

There is continuous inflow of funds from the foreign markets, causing our markets to make and break new highs at an unprecedented pace. However there are risks of an economic slowdown in India owing to the Reserve Bank of India's tight monetary policy and of mid-term elections as a result of political instability.

 

Keeping all the analysis aside, if markets are good at one thing, it’s reminding investors that they don’t go up uninterrupted forever. But remember, fear is not an investment strategy and nor is greed. Your only real insurance against the unpredictable is having and sticking with a long-term ‘strategic’ asset allocation plan.

But the market's going up ... and I'm missing out on gains

Many investors get this thought, ‘if I stay out of this Bull Run, I will miss out on gains’, - and it's a typical situation - the market starts recovering and embarks on an upswing. You read notes everyday that reads something like ‘How to make most of the rising markets?’ or ‘Where to invest to make gains from this Bull Run?’. Everyone thinks this is the time to get in as they have already missed out in the past rally. Sure, sometimes this is true -- but investors need to be cautious at a time like this.

Of course, when all the factors are moving in the right direction - GDP growth is robust, the rupee is strengthening, cash is pouring into major companies, and companies are reporting healthy earnings - the market has reason to rise in value. But apart from these economic factors, the supply and demand for a company’s stock is also important in determining where its price will end up. If enormous demand gushes into the market, driving prices up without any data to support those appreciating prices, investors’ returns will not be permanent.

As intriguing as it may seem to try to catch every market wiggle in order to reap big profits (or so you think), the “tactical” or shorter-term approach to investing has its limitations. And it’s risks.

The market goes up and down. It’s inevitable. Each time the market drops, and it will frequently and without warning, many investors stray from their plan. Yet, most market gains occur in just a few strong but unpredictable short-term periods, like we’re seeing. To maximise the long-term performance you have to be in the market during those periods.

Consider what happened in July-August’07, the markets fell sharply because of the US sub-prime crisis and global meltdown. There were all the talks of crisis and predictions of big market crash. Were you then able to predict that the markets would trade at record highs and the Sensex would reach at 19000 levels in a span of less than 2 months? Probably not. And at the riding 19000 Sensex level, was it possible to predict that the markets will plummet 9% in just a few seconds, which it did on 17th October 2007 (Sensex lost 1743.96 points and Nifty slipped 524 points), in reaction to Securities and Exchange Board of India’s announcement to curb the foreign inflows through Participatory Notes.

The fact remains that it is impossible to predict the markets and the right investment strategy is to stick with a long-term plan. So whether the markets are up or down, a disciplined investment approach is the key to wealth creation.  These decisions are not a function of short-term market gyrations or forecasts, but are tied to your risk tolerance and long-term goals. Developing and maintaining the right long-term asset mix is the most important set of decisions that will help an investor to generate wealth.

Now the question is how?

A brief outline on fundamentals of investing and devising a strategic asset allocation plan:

Know yourself

You need to understand yourself before you device a plan like

  • How much risk you can stomach in?
  • What is your investment timeframe?
  • What are your income needs – buying a house, providing for our child’s education, preparing for daughter’s wedding or for making sure that there is something to pass on for our future generations.

Understanding these factors will help you in creating a well-considered investment strategy.

Asset Allocation and diversification

We have often heard that there are very few free lunches in the world of investing. Asset allocation and diversification are as close as you can get.

  • Reduce your risk by dividing your portfolio among several asset classes like equities, bonds, cash and real estate. You can also diversify within an asset class by investing in different types of securities within that class. Also consider going international. Diversification is one way to protect you from unpredictable market declines.
  • Build a long term plan and stick to it. Many investors shy away from equity investments because of concerns over their perceived volatility. They assess the short-term volatility of equities - which can create exceptional returns as well as significant declines - and stereotype the equity returns with these unpredictable returns. History would suggest otherwise. Traditionally, equities are likely to become less volatile the longer they're held, while continuing to provide compelling growth potential. You should focus on longer trends, not temporary fluctuations.

To emphasize the point of long-term plan, take the example of home ownership. There are key psychological reasons a home is a great investment. You’re not likely to sell your house to satisfy a whim or to escape a bear market.  By considering the same long-term commitment when investing in the stock market, you will reap similar long-term benefits. If you understand the market and expect it to fluctuate, you will not be tempted to alter your plan every time you see a shift in the market sentiments and stick to your long-term plan.

And finally, monitor and rebalance your portfolio

Markets, investment choices, tax rates and your life - all change. You may need to rebalance your portfolio annually, or when any life changes impact your assumptions—for example, if you retire early, or your financial situation changes.

Even if everything remains the same, the returns from your portfolio would alter the asset allocation or might allure you to alter it. During booming markets, most investors do get tempted and add more to equities, rather than book gradual profits, leading to an asset allocation mismatch, which is most painful if markets correct suddenly. Or higher returns from your equities would increase the equity percentage in your portfolio. Rebalancing exercise will help you to get all the asset classes back to their original allocation percentages and within your desired risk profile.