No end to volatility in sight: What should we do: Part 2

In our previous blog, No end to volatility in sight: What should we do: Part 1 we discussed about the ongoing volatility in our stock market. We also discussed how difficult it is to make any kind of predication, except that the market may continue to go down in the short term. However, if you develop a deeper understanding of the market and its drivers, both in the short and longer term (as discussed in Part 1), you will not only be better prepared to handle the volatility related stress but also make the right decisions. Knowledge is your best friend and fear is your worst enemy. Your other two good friends are your discipline and rational intelligence. We will discuss how they will help you navigate through these difficult times.

• Be focused on your goals:

  Your retirement goals will not change, no matter what the stock market does in the short term. If the stock market goes down by another 10% this year, will you reduce your retirement goal by 10%? Will your goals towards your children’s education depending on the stock market? It will not. Our point is that, you should always remain focused on your goals. Market and politics will do what they have to do. Equity has been and will always be the best asset class to create wealth in the long term. Bear markets do not last forever. The recovery is usually sharp and will take you to a new high (please read our article, Making sense of volatility in the equity market: A Historical perspective). You should stick to a disciplined investment plan, so that you can meet all your financial goals. Also, do not try to outguess the market. In the past one year, many investors and financial advisors believed that midcap funds will give good returns, even if large cap funds underperform. The premise for this belief was that, FIIs invest in large caps and so their activity has an impact on large caps; small and midcaps are immune to FII activity. This belief would have paid off in the last one year, as small and midcap funds have outperformed large cap funds. But if we think that this trend will continue indefinitely, then we are wrong. In fact over the last few days, small and midcap companies have seen sharp cuts in share prices. As discussed previously in a number of blogs, midcap valuations are as rich as large caps, if not more (see our article, Should you invest in large cap or midcap mutual funds). This is clearly an anomaly and will get corrected at some point of time in the future. Midcap valuations cannot be higher than large cap valuations in the long run. In fact, in the last few days, we are already seeing signs of the midcap index correcting quite significantly relative to the frontline index. You can continue to be in midcaps if you have a long investment horizon. But do not expect fantastic short term returns from midcap funds. Prudent portfolio construction norms suggest balanced allocation between large cap, midcap and diversified equity funds.



• Have a good investment strategy:

  We have seen that the market has been very difficult for almost a year now. We have also discussed that, it is very difficult to call a timeline to the end of volatility. So while volatility will not end next week or even next month, and at the same time, history tells us that it will not continue for the next 5 years. A bear market never lasted for a long period, spanning many years, except during the worst economic crisis of modern times, the Great Depression. So what should you do? Here, we should distinguish between short term traders and long term investors. We have mentioned a number of times in our blogs that unless you are an expert and experienced investor, you should always stay away from short term trading. I have seen most retail investors actually losing money in intraday or short term trading. Nevertheless, even if you are short term trader, it is better to stay in cash at this point of time, because it is easy to lose money, when market trend is extremely volatile and downwards. If you have to trade in this market, you cannot go against the trend of the market. The market trend is downwards. Refer to the chart shown above. Nifty is making lower tops and lower bottoms. It is a bearish chart, the intermediate spikes notwithstanding. The 200 daily moving average (DMA) is above the 100 DMA and the 100 DMA is above the 30 DMA, which clearly signals a bearish market.

Source: Equitymaster

If you have to trade in this market, it is better to trade on the short side with tight stop losses and book profits as soon as your target is hit. We are saying this for indices like Nifty or Bank Nifty. Individual stocks may behave differently. If you are trading in stocks, avoid averaging if share prices go down. It is usually the worst mistake to make, because other than emotional satisfaction that your average share price is lower, it serves no other purpose, if you are a short term trader. Remember again, that if the trend of a stock is down, it will continue to go down. On F&O expiry you should avoid rolling over your positions. Do not ignore stop losses otherwise you can get burnt badly by triggered margin calls, if the market goes the other way. This strategy applies to both stock F&Os and the index. If you are trading in options, be mindful of implied volatilities. Implied volatility is baked in the option price premiums. In India, the implied volatilities are usually higher than normal. Therefore if you buy options, whether call or put, the premium is usually high and that makes your trade unprofitable in many cases, even if you get your call right. For example, today (January 13th 2016) Nifty January 7500 put is selling at almost र 80, which means if you buy a January 7500 put option thinking that the market will go down, you will be making a loss, unless Nifty goes to below 7420 before the expiry on January 28, 2016. When implied volatility is high, it is more profitable to sell options (call or put) than to buy options. That is what most professional traders do. But retail investors should avoid selling options, because the loss can be unlimited. In volatile markets, such as the one we are seeing now, if you get your call wrong in selling options, you will be making big losses by selling options. For example today (January 13th 2016), the market gave a good gap up, then gave up all its gains and went down 1% from the day’s high, and yet by close recovered all the losses and closed 0.7% higher than previous day’s close. If you sold a 7500 put yesterday or today based on market movement, you will be sitting on big losses today and your broker will be calling you to fulfil your margin requirements. If you are selling options, you should ensure that you have enough margin money and tight stop losses. Same applies, when you are trading in index or stock futures.

What should long term investors do? First of all do not panic. As discussed earlier, be focused on your goals, because that is what matters at the end of the day. So if you have invested in high quality stocks or equity mutual funds that gave you good returns in the past, remain invested. I remember, back in 2008 many investors redeemed their mutual fund units. With the benefit of hindsight, it was a mistake and many of those investors regret it even today. If you are investing through SIPs, you should continue your investment. You will be buying units of your mutual funds at a lower cost. The long term return on your investment will be fantastic. If your friends or relatives invested through monthly SIPs throughout 2008 or 2011, ask them on how much profits they are sitting today. It is a no brainer. When stock markets rebound, especially here in India, they scale all time highs very quickly indeed. If you have lump sum money waiting to be invested, explore the option of putting your money in a liquid fund and doing a systematic transfer plan (STP) to equity funds of your choice, monthly or fortnightly, over a 6 to 12 month period. This will have the same effect of an SIP with respect to better price realization, with the additional advantage of higher liquid fund yields compared to your savings bank. Alternatively, if you are a smart investor who follow stock markets on a regular basis and have faith in technical levels, you can use your lump sum investments to tactically increase your asset allocation to equities, whenever an important technical level is hit on the downside. While, this may work out to be a better strategy for more informed investors, the STP from liquid funds is probably the better strategy for the average investor in such market conditions.

As far as choice of funds is concerned, while many retail investors may have a fascination for small and midcap funds, based on their performance over the last one or two years, diversified flexicap or multicap funds are, in our opinion, the best investment choices for retail investors (please see our article, Mutual Fund Diversified Multicap funds are ideal for retail investors). These funds invest in both large and midcap companies across sectors and have the potential to do well in different market conditions over a long investment horizon. As discussed earlier, the margin of midcap outperformance may not be sustained over the coming years, because midcap valuations are no longer cheap relative to large cap valuations, a situation that cannot last for very long. Investors should avoid sector funds, unless they are knowledgeable about the sector and know when to time their exit. Balanced funds are excellent investment choices for new investors. These funds invest up to 35% in fixed income securities and are considerably less volatile than equity funds. The long term wealth creation and income generation potential of balanced funds is also quite substantial (please see our article, A smart option for getting regular income from your Balanced Fund investments over a long period). More conservative investors can also consider investing in hybrid debt oriented funds, which invest 70 – 75% in fixed income and only 25 – 30% in equities. Though the risk is considerably lower than equity funds or even balanced funds, given where equity valuations are today, even these funds can get you substantial capital appreciation over a long investment horizon, in addition to generating regular income for you.

Conclusion

These are tough times indeed for the equity investor. But I am reminded of a dialog from a Hollywood movie of the 80s. It is easy to make money in bull markets. Bear markets test the character of an investor. Those who are disciplined and make smart decisions in bear markets are the ones who come out with flying colours in creating wealth. But be under no illusions. The difficulties this market is facing are not going to get resolved tomorrow or any time soon. As an investor, what the market does is not in your control, but how you react to it is definitely in your control. If you remain focused on your goals, stay disciplined and have faith in the India Growth Story, hopefully you will reap rich dividends in the long term future.