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.

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