How to manage your mutual fund investments in volatile markets

One of the most famous quotes of Warren Buffett is “You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ”. Superior emotional quotient (EQ) plays a far more important role than high IQ in Investment success. EQ or emotional intelligence is the ability to recognize to our own emotions, as well as of others and level correctly. Research has shown that people with high EQ are less affected by fear and greed. They take a more balanced approach towards investments. They also tend to trade less, make less change to their investments and are usually able to get better results in the long term. Our emotional intelligence in investing faces a stern hard test in volatile markets

Over the past 2 years or so the equity market has been quite volatile. Every few months, over the past 20 months or so, the market faced uncertainties due to a variety of global factors, the Euro zone debt crisis, the Chinese economy and currency devaluation, Brexit, US Fed Rate hike, US Presidential Elections, events in our economy etc. The Nifty fell more 20% from its all time high (February 2015) and since then has risen 20% from February 2016 lows; volatility has been a fairly constant feature of this market. The steady flow from Indian retail investors over this period is a testimony to the growing maturity of our retail investor base, but nevertheless, when you have invested your hard earned money in stocks and mutual funds, it is natural to feel stressed in times of volatility. On the other hand we must understand that, volatility is an intrinsic aspect of equity as an asset class.

Managing your emotions in volatile markets

Warren Buffett thinks that, “greed and fear” guide behaviour of most investors. Runaway bull and bear markets are caused by irrational exuberance and panic respectively. If all investors were rational we may still have bull and bear markets, but we would not have high volatility. Irrational exuberance and pessimism cause us to lose money, at the end of the day. To be a successful investor, it is less about managing your investments in volatile markets and more about managing your own emotions.

The first rule is not to panic in volatile markets. When we panic we are not thinking clearly and usually end up making the worst decision. Many investors that I know, who panicked and redeemed their investment and stopped SIPs in 2008, were regretting just 2 years later. Not getting emotional about investment is easier said than done because getting worried when your investments lose value is only a natural human reaction. Therefore you need to make an effort to stay calm and focused.

I was reading a recent post on a leading online financial journal on the investing views of famous Bollywood actor, Hrithik Roshan. While we all know that, Hrithik Roshan is Bollywood superstar, he is also a successful private equity investor, who recently sold his fashion brand to an e-commerce major. As per the online journal, Hrithik Roshan also made investments in a variety of asset classes. Roshan told the journal that, investing money to make more money “should always have a goal”.

What Hrithik Roshan said, is also a regular narrative of our blog in Advisorkhoj. Investing should always have goals; bull market, bear market, range bound market, volatile markets are all part of the journey towards the goal. If you are focused on your goal, what comes in the journey towards the goal will not be a distraction. Focus and discipline are two important aspects of emotional intelligence in investing.

Volatility can be a friend in your long term investment journey

In volatile market conditions you should make volatility work in your favour, through a principle called rupee cost averaging. By investing a fixed amount of money on a regular basis (weekly, monthly etc) across time in mutual funds, you can average out your cost of purchase. Basically, you buy more units when the price is less and less units when the price is more. Rupee cost averaging works for you by reducing your average cost of acquisition thereby enabling you to earn higher returns.

You can achieve this through Systematic Investment Plan (SIP). In a systematic investment plan, you invest a fixed amount of money on a regular basis (e.g. weekly, monthly etc) in a mutual fund scheme. SIPs work very well in volatile market conditions through rupee cost averaging. SIPs also help the investors stay disciplined. By investing a fixed amount out of your regular savings, you will be able to build a corpus for your long term financial needs. Money not invested often gets spent on consumption and compromises the long term goals of the investors.

We have discussed the many virtues of SIP, a number of times in our blog; so we are not going to belabour the point of SIP benefits, but a look at the SIP returns over the last 10 years, which included periods of extreme volatility (please see Top Performing SIP funds in 10 years), never ceases to amaze me about the power of disciplined systematic investing. SIP is a simple to execute, yet extremely powerful tool, which enables you to take advantage of volatility and create wealth in the long term, out of your regular savings.

Tactical Asset Allocation to equities in volatile markets

We have said a number of times in our blog that, over a sufficiently long period of time, equity is the best performing asset class, at least based on past many years of history. A few weeks back, I was watching a debate on a popular TV channel on whether equity or gold was a superior asset class. While the gentleman who was debating on behalf of equity and equity mutual funds cited data as to why equity was a superior asset class, the gentleman on the other side of the debate, a jeweller of course, espoused the cause of gold. Unfortunately, the jeweller was resorting only to rhetoric and not any data. For his cause, the jeweller did not have to support his rhetoric with data, because we (Indians) have a cultural affinity to gold; but that does not change the reality.

Please visit our tool, Mutual Fund Comparison with Asset Classes, and you will be able to see that, equity mutual funds is the best performing asset class over most long term timeframes.

Deep corrections present wonderful opportunities to tactically increase your asset allocation to equities. Sometime back, I was speaking with an investor. He told me that he does not look at stock prices or mutual fund NAVs in his portfolio during bull markets. However, he pays close attention to stocks and mutual funds during market downturns. Market downturns, especially the sharp ones, he believes, present good buying opportunity and can lead to great long term returns for him. Market downturns also help him identify the solid performers and replace the relatively weak performers with the solid ones; more on that later.

STP can be very effective in volatile market

Tactically increasing your asset allocation to equities in times of downside volatility can do wonders to your long term portfolio returns. However, some investors asked me, how they would know when the market bottoms out. Waiting for market to bottom out can often result in lost opportunities. If you have a lump sum amount that you to invest, but you are not sure when to invest because of volatile market conditions, you have two options. The first option is to keep your money in a savings bank account and invest it through an SIP in a mutual fund scheme of your choice till the entire lump sum amount is invested. A fixed amount will be auto-debited from your bank account and get invested in the mutual fund scheme.

However, there is a better option, in which you can park your lump sum amount in a low risk debt mutual fund, also known as liquid fund and transfer a fixed amount on a regular basis through a Systematic Transfer Plan (STP). An STP works exactly like an SIP, except the money towards your investment is debited from another mutual fund scheme (e.g. liquid fund) instead of your bank account. The mutual fund company will redeem the units of the transferor fund (e.g. liquid fund) equivalent to exact amount of money that you want to invest in the transferee fund (e.g. diversified equity) at an interval chosen by you (e.g. monthly). This option is better than keeping your money in a savings bank account and doing an SIP because liquid funds usually give much higher returns than your savings bank interest rate.

Asset Allocation in volatile market

Do not forget your asset allocation during volatile market conditions. Your asset allocation is governed by your risk tolerance and financial objectives. Booming bull markets or sharp prolonged corrections skew your asset allocation. For example, if your optimal asset allocation is 60% equity and 40% debt and the market appreciates 30% in a few months, your asset allocation will get skewed to 75% equity and 25% debt. This may not be consistent with your risk profile. In such a situation, you should rebalance your portfolio to shift from equity to debt. Similarly if the market falls sharply, your asset allocation will be skewed to debt. In such a situation, you should rebalance your portfolio by investing additional funds in equities or shift from debt to equities depending upon your financial situation.

Separate men from the boys

Volatile markets help you identify the solid performers from the weak performers. In a bull market everyone looks like a star. However, for your portfolio to give good returns in the long term you need your portfolio to be made up of consistent performers. As the legendary Warren Buffett famously said, “Only when the tide goes out do you discover who's been swimming naked”. Your equity fund may have given 30% return in the last one year, but has your fund manager delivered the returns by taking excessive risks. In a market downturn you will be able to evaluate which funds in your portfolio has more downside risk than upside risk, on a relative basis.

It has been proven that consistent performers over a long time horizon give better returns than funds who give high returns in the short term. You should use a market downturn to separate out the solid performers in your portfolio from the relatively weak performers, and then reshuffle your portfolio to replace the weak performers with more consistent performers. But one should not judge a fund based on just short term performance. You should evaluate how it is has performed over a period of time during both, market rallies and downturns.

Arbitrage funds for parking short term funds

Arbitrage funds are good short term investment options in volatile markets. Arbitrage funds are low risk investments and benefit from market volatility. In volatile markets, arbitrage funds can give higher returns than liquid funds, and certainly more returns than bank deposits. The added advantage of arbitrage funds is that the returns are tax free if they are held for a period of over one year.

Conclusion

In this article we have discussed some important rules to manage your investment in volatile market. Smart investment decisions taken in volatile market conditions can help you significantly enhance the return on your investment. More importantly, you should stay disciplined and stick to your investment plan. Remember equity investment is for the long term, so you should not be bothered with short term volatility.