Investing in Mutual Funds and Equities in surging bull market

In 2014 the Sensex surged by 30% giving handsome returns to equity investors. Mutual funds saw the highest inflows in over a decade. The start of the New Year has not been great for equity markets. In just about a week, the Sensex fell by nearly 1000 points. There are questions about the global economy especially the situation in Europe and crude. Some retail investors are waiting on the sidelines for a deeper correction to get into equities. The question for such investors is, "what is the right level to enter this market". As per some market pundits, we may see a further correction over the next few weeks which may take Nifty to 7,800 – 7,900 from the current levels of around 8,280 if the market gets negative global cues. There are others who are of the opinion that Nifty may test its historical highs before a significant correction. This scenario may pan out, if ECB steps in with quantitative easing, crude prices bottom out and if our corporate earnings are not disappointing. There are yet others, who believe that the Nifty will be range bound in the absence of any major event and mixed earnings. The point is that, equity markets are uncertain in the short term.

Timing the market is difficult

Large sections of the retail investor population missed out on the bull market from 2012 to 2014. While it is natural for retail investors to be wary about equities after a prolonged bear phase, a lot of investors simply kept waiting for correction once the market ran up significantly. It is not as if we did not have corrections in the last 2 years. We had a quite a few, but with every sharp correction these investors thought there would be more downside to the market. The important point to note about bull markets is that, after every sharp correction the pull back is very strong and the market goes back to pre-correction levels in no time (please see the chart below).

We can see in the chart above that, rallies after corrections have been quite sharp. Bull markets do not give enough time for investors to enter after corrections. In fact, investors waiting for corrections, often end up buying at much higher levels. Disciplined investing by averaging your purchase cost is a much more prudent approach for long term investors, than trying to time the markets.

Let us understand with the help of an example. Let us assume we are in 2013. You invested in a disciplined systematic way by investing in the Nifty on the first working day of every month throughout the year. The average value for your investment in Nifty would be 5,908. Your friend, on the other hand, wanted to time the market. While it is impossible to know if the market is at its lowest level, let us assume for the moment that your friend was very lucky. He got it spot on and invested in Nifty on August 28 at 5,285 which was the lowest level of Nifty on a closing basis in the last 2 years. Apparently compared to you, your friend got a great bargain. But let us now be realistic. It would have been practically impossible for your friend to know on August 28 that 5,285 would have the bottom of the correction. In fact since Nifty was on declining trend from June to August that year, he would have waited beyond August 28 to see if it corrected further. If he waited for 7 days, Nifty would have been at 5,680 which is just 4% below your average cost. If he waited for 15 days, he would have invested in Nifty at a higher cost than your average cost. Such is the nature of bull market. Buy on dips is the age old investment advice for bull markets. Disciplined investing, such as mutual fund systematic investment plans (SIPs) ensures that you can buy on dips rather than waiting forever for a deep enough correction.

Is volatility and risk one and the same thing

As per finance text book definitions, volatility is a measure of risk. By its very nature, equity as an asset class is volatile. While bear markets are usually characterized by higher volatility, even bull markets are volatile. But is volatility is the same as risk for long term investors? It is true that, we as investors get jittery with volatility. There are mutual fund investors who made 30% in the last one year, ready to jump out if the market fell by 5%. Good diversified equity funds gave compounded annual return of over 20% over the last 10 years, even including the prolonged bear market phase, when the market fell by more than 50%. Why should a 5% correction matter to the long term investor? Once the investor understands the nature of a multi-year secular bull market, the investor should be able to ride out the volatility and get good returns over a sufficiently long investment horizon.

Nature of a secular bull market

There are three phases of a multi-year secular bull market.

• Early Stage: Early stage of a long term secular bull markets is characterized by high expectations and generally low economic growth. Equity returns are high because stocks bounce off the bottom. Usually large cap stocks do well in this period relative to midcap stocks. As the market transitions from early stage to mid stage, the economic outlook gradually improves. As the bull market matures, midcap starts outperforming in terms of returns. The Indian equity market, experts argue is in the early stage of a multi-year secular bull market, since it is characterized by the attributes described for this stage.


• Mid stage: The economic outlook keeps improving through the mid stage of the secular bull market. Corporate earnings show higher growth during this stage. While most developed equity markets grow at the pace of earnings growth, in a market like ours the growth is even higher as positive sentiments pushes up valuations (P/E ratios). The mid stage of the bull market is the longest stage and can last for many years. For our market, this can be especially a high growth stage if the Government implements its agenda of structural reforms. It is important for investors to remain invested in equities, because during this stage they can benefit from the power of compounding of returns.


• Late stage: This stage is characterized by high corporate earnings and GDP growth. High levels of exuberance sets in the market. Stock prices rise the fastest during this phase. Investors will recall how the equity market was in 2007. Market pundits, all of them turn bulls in this stage, start talking about new paradigms. Remember, how they talked about Indian market being decoupled from global markets, when there were early warning signals of a global recession. Unfortunately many retail investors enter the market at that stage attracted by high equity returns. When the market cycle turns, as it inevitably does, the late entrants lose out the most. The smart investors exit the market towards the end of the late stage. However, just like timing your entry in the market is extremely difficult, as discussed earlier, timing your exit is equally difficult. Having said that, even if you are not able to time your exit, if you have long time horizon for your equity investment, you can still make very good returns. For example, if you invested in ICICI Prudential Top 100 fund in 2003 and exited at the bottom of the bear market in 2008 (when the market fell almost 50% on a year on year basis), you would still made a compounded annual return of nearly 24%.

Conclusion

In this article, we have discussed that timing a bull market is difficult. Investors should follow a disciplined approach by investing in mutual fund systematic investment plans to get good returns to take advantage of volatility and buy on dips. Investors should not be worried about volatility and have a sufficiently long time horizon to benefit from the power of compounding. Most importantly, investors should ensure that their asset allocation is aligned with their investment objectives.