Saturday, August 20, 2011

Market Correction

Investing in uncertain times

There is mayhem in the markets. Here's what small investors should do to cushion their portfolios against the downturn
There is no hard and fast definition of the term "Market Correction". A stock market correction is when the stock market declines 10% or less in a relatively short period of time. It's a natural part of the stock market cycle. Corrections are inevitable. When the stock market is going up, investors want to get in on the potential profits. This can lead to irrational exuberance. This can make stock prices go well above their underlying value.

A correction is different from a stock market crash, which is when stock prices plummet more than 10%, often in just one day. Unlike a correction, a stock market crash can cause a recession. How? Stocks are how corporations get cash to grow their businesses. If stock prices fall dramatically, corporations have less ability to grow. Businesses that don't grow will eventually lay off workers to stay solvent. As workers are laid off, they spend less. Lower demand means lower revenue. This means more layoffs. As the decline continues, the economy contracts and you have -- Voila! -- a recession.

If a correction is relatively benign, and a crash can cause a recession, how can you tell the difference? It's not easy. A correction can turn into a crash if the stock market declines more than 10%. Trying to decide if a correction is turning into a crash is known as timing the market. This is nearly impossible to do, since there are so many factors that can influence the direction the market goes in. However, the markets soon regain their confidence, reverse course and begin to head higher once again.
The worst thing to do right now is panic. Over-leveraged speculators and panic-stricken investors were the only ones who lost money in the 2008-09 crash. For the disciplined long term investor, the spectacular decline in the markets that saw the Sensex hitting a multi-year low was actually an opportunity. A bit of data crunching would reveal that there is virtually no risk if you invest in stocks for the very long term (5-7 years on an average).

Here are a few steps that can help cushion the impact of volatility and ensure that investors don't get carried away by the predictions of doomsayers.

Don't stop the SIPs
Don't even think about terminating your SIPs at this point. It's the worst thing you can do to your portfolio and would defeat the very purpose of the SIP. If you stop now, you are effectively turning down the chance to buy more at lower prices. It's a common mistake that can prevent your attempt at rupee-cost averaging. The impact cost of stopping a Ulip premium is higher than terminating an SIP, so many investors opt for the latter.  The investors should automate their investments so that there is no discretion in their reaction to the noise emanating from the stock market.

Stick to Blue Chips
It's now amply clear that the economy will take some time to regain momentum. Slower growth rates, high inflation and high interest rates are here to stay. When the economy was growing at 9%, the tide has lifted all boats and the mid-cap and small-cap companies flourished. Now, with economies projecting a GDP growth of 7-7.5%, only large companies will be able to clock good growth, while the mid-sized companies will barely manage to stay in the green. Smaller companies will have to struggle and could easily slip into losses in the situation worsens. It's the best to stick to large-cap stocks at this time instead of risky mid-caps and smalls-caps.

Diversify your bets

The infrastructure sector has been badly beaten down but analysts expect it to do well when the economy revives. It's a good time to start nibbling at some infrastructure stocks at these beaten down levels. Even so, don't put all your eggs in the infrastructure basket. Spread your bets and risks -  across a basket of Metals, IT, FMCG and Banking sectors stocks at such throw away prices..

Rupee-Cost Averaging

The markets are down to attractive levels but there is no knowing where the bottom is. It's best not to anchor yourself to an index -  say 4000 (Nifty) or 14000 (Sensex). To avoid buying high, don't invest lump-sum amounts, but do so in monthly installments. In this manner, you will be able to gain the advantage of the rupee-cost averaging that the SIPs offer.

Friday, August 19, 2011

Investor Type

Your investment style will not only determine how you behave during a market crisis, but also help you take the right decisions.

Uncertainty, which breeds fear of the unknown, hinders an investor's ability to make rational decisions. When the markets are buffeted by negative news from around the world and the general consensus is that the worst isn't over, investors become confused about the course of action they should take. The overload of information and analysis makes things tougher. Ultimately, how he behaves during a crisis will depend on the kind of investor he is. The investors who are financially weak may not be able to participate in every kind of market and should know when to keep out. So, risky markets are not for a person who is, say, rolling over his credit card dues, or is paying a large EMI for house that is yet to be delivered, or is worried about not earning or saving enough. The investors who have a limited corpus or significant liabilities, and senior citizens with a low risk appetite are better off not taking drastic measures in risky markets else they can loose much more than they can afford.

Strategic investors, on the other hand, focus on building long-term wealth. They are smug in the knowledge that 10 years on, the events that seem cataclysmic now will be pale into insignificance. They stick to an allocation pattern - say. 50% in equity, 30% in long-term debt, 10% in short-term debt, and 10% in gold -- and earn reasonable returns across market cycles. Sticking to one's allocation means continuing to invest in equity even as the market falls and keeping money aside in debt even if the equity market rises. A strategic investor does not care much for market cycles. Instead, he has faith in the power of  time to even out losses. For such an investor, panic-driven crashes in the market are opportunities to reduce the average cost and even out the expensive pricing of the preceding boom. The losses during the downside are taken in stride as an essential biter pill in order to be present in the market when it turns up. This breed does not use borrowed capital, and is not in a hurry.

Tactical investors are the ones who are tested the most during any uncertainty. This breed lies to predict how asset classes are likely to perform, and based on the macro picture that emerges, it tries to modify the portfolio to protect it from losses. For instance, a tactical investor would reduce his exposure to equity if he foresaw any risk to global flows. He would also increase the exposure to gold in an attempt to cash in on the clamour for a safe investment in turbulent times. In the face of an expected drop in a global demand, this group would reduce the exposure to commodities. or would avoid long-term debt if a jump in market and credit risk was on the cards. Obviously, not all calls can be accurate. Tactical investing needs expertise and skill in reading the market signals, as well as the ability to reallocate assets. The investors who see themselves falling short in either department should keep away.

Some investors enjoy event-based trading. Here, the temptation to buy an asset that is moving up is high. This group uses available information, even if it's partial, for a quick take on an event before making a move, hoping to make money from the resulting volatility. Such investors should focus on the capital in hand and be willing to book losses if their call goes wrong. The amount they allocate to an asset after reading the signs should not be too large a component of their wealth, as it can wipe them off. 

There are bound to be problems if the investor's behaviour in uncertain times does not match his type. So a strategic investors gives in to panic and quits the market in haste; an event-based trader stakes a large chunk of his portfolio in what everyone is chasing but fails to exit in time; a tactical investor assumes that all his calls will hit the bull's eye and borrows funds to add to a position he holds, making a risky bet riskier;  a financially weak investors hopes to make good an earlier loss but ends up repeating his mistakes.

Hence, it is crucial to identify the type of investor you are, to think through your action plan and focus on your wealth before you act on the market information.