The stock market has seen considerable volatility over the last one month or so. In our last post, What should you do in falling stock market: Part 1, we discussed how easy monetary policy (low interest rate regime) globally, fueled huge rally in stock prices for the last 5 years. Now as the US Federal Reserve looks to tighten interest rates more aggressively than what the market was anticipating, stock markets have turned nervous and volatile. As nervousness increases in the market, global investors shift funds from equity to safe assets like US Government bonds causing stock prices to fall. The interest rate related volatility in the market may last for some time. Finally, as always, the volatility will subside and the market will react to fundamentals like GDP and corporate earnings growth.
Long term investors among Advisorkhoj readers will have seen many cycles of stock market volatility in the past and at the end they see market making new highs. However, we do realize that volatility, as long as it lasts, can be stressful for some investors. It is not easy to see, investments made with your hard earned money falling in value – sometimes fear causes investors to make wrong investment decisions. Investors can also make wrong decisions due to over-excitement.
In this blog post, we will discuss how a systematic approach to investing can help you navigate through volatile markets.
How long will the market correction last?
Some investors may be wondering how long with this volatility continue or for how long will the market fall. It is not possible to predict what the stock market will do in the near term, but historical data shows that, corrections or even bear markets do not last for very long. Historically, a 10 – 15% correction usually lasted for about 3 to 4 months – the market then bottoms out and up trend resumes. The Nifty-50 has fallen about 7% from its all time high in the last month or so. The market can fall a few more percentage points, but as long as the correction is within 10 -15%, investors can expect the market to start recovering within a few months. In times of high volatility, even 3 – 4 months can seem like a long time, but patience is the key in such times to ride out the volatility.
When the market falls more than 20%, the correction is termed as bear market. A bear market is more severe than a bear market. A bear market usually takes a year to bottom out and start recovery. In the last 10 years, the market fell more than 20% in 2008, 2011 and 2015 / early 2016. Each of these corrections lasted for 12 months or less, even the crash of 2008, when the market fell more than 50%. However, considerable price damage may be done to some stocks in a bear market and these stocks may take much longer to recover if at all. In bear markets, we often get text messages or emails from stock analysts saying that, so and so stocks have fallen 50% and are now very attractive. Be very careful.
Volatility, corrections and bear market all look the same at the beginning. If the market is down 6 – 7%, how do you know if it will fall 10% (correction) or 20% (bear market)? You do not. You have to work with the information you have. If the market has fallen 7%, then you should prepare yourself mentally for a 10% correction – the preparation entails only a bit of patience. If the market falls 15%, you should prepare yourself for a bear market. Liquidity can become a problem for investors in bear market and therefore, proper asset allocation (mix of equity, debt and money market) is important in bear markets.
Have realistic expectations
You should have realistic expectations in volatile markets or market corrections. If market has corrected 10%, expect your equity portfolio to be down by 10%. If your equity portfolio is aggressive, high allocation in mid and small cap stocks / funds, then expect your portfolio to be down more than the market. If the market has corrected 10% and your mutual fund portfolio is down by only 5%, it is great for you; your asset allocation or fund selection protected you from the market downside. However, if your portfolio has fallen more than the market, do not feel depressed because the underperformance might be due to the beta of your portfolio. The same beta would have helped your portfolio outperform in bull markets. You should be concerned about underperformance, when your mutual funds underperform both in bull market and bear market.
Do not panic
If your portfolio is down 15%, do not panic that you will lose all your money and call your financial advisor to redeem your investments. Even if your portfolio has fallen 15 or 20%, 80 to 85% of your money in the portfolio is still there. Bull markets follow bear markets, and bear markets will follow bull markets – markets go up and down, it is inevitable. The problem is not with market, but with our own expectations. Investors tend to think that, whatever the current environment, bull market or bear market, it will go on forever. Your emotions in volatile markets, unless kept in check, can not only cause stress, it can also lead to very bad decisions. Patience is one of the most important qualities in emotional intelligence and leads to investment success in the long term.
Bottom fishing can be risky
In market corrections or bear markets, stock prices can fall substantially. Investors often get calls from their stock-brokers to buy stocks will have fallen so that they can average out the purchase price. A well known stock broker once compared buying falling in a bear market, to catching a falling knife. Catching a falling knife may cut your hand and cause serious injury depending on how fast the knife is falling. It is true that, some stocks in bear markets can appear to be available at bargain basement prices, but bottom fishing can be quite risky because, as discussed earlier, a bear market can do considerable price damage to particular stocks and the recovery time frame of such stocks can be very unpredictable.
It is better not to play the game of bottom fishing because the big financial institutions have information advantage that is tough to compete with for retail investors. The best strategy in a bear market is not doing anything- remain calm and remain invested. If you want to invest in a bear market, then investing in diversified equity mutual funds with a long investment horizon is the best options for investors. Mutual fund managers have better information resources, access to management and industry channels to make investment decisions in any market condition.
Read why diversified equity mutual funds are good long term investment choice
Turn off the TV
This may sound like a funny advice, but I have found it useful in many stock market corrections or bear markets. During bear markets, it is not uncommon to see the Sensex falling four or five hundred points within minutes of opening. The panicked anchors proclaiming that the market is crashing will only aggravate your fragile nerves and cause doubts in your mind about your investments. Sometimes investors want to understand what is happening in the market from experts on TV. You should understand that events in stock markets can be explained only in hindsight; when an event is unfolding, all views are mere conjectures. In falling markets, instead of worrying about your investments, you should focus on your other work and wait for this market phase to pass.
Stick to systematic investing
In a falling market, it is difficult to know how much will share prices fall and for how long they will fall. Systematic Investment Plans work wonderfully well in bear markets because you will be purchasing units of mutual funds at lower prices. Systematic Investment Plans in volatile markets reduce your investment cost through rupee cost averaging and give you higher returns in the future. Deeper the correction, the better will be your returns over a long investment horizon.
SIP in a deep market correction may seem like throwing your good money after bad because the more you invest the more your investment falls in value. Many investors panicked in the financial crisis of 2008 and stopped their SIPs / redeemed, when the Sensex was at 8,000 or thereabouts. Many of these investors re-entered when the Sensex was at 25,000 or more. In India, the stock market tends to rally furiously from market bottoms and it is very difficult to get an entry in a bull market, as many of you may have experienced. Therefore, it is not prudent to exit your equity investments during bear markets. Once the market recovers from a correction, your SIPs can give you superlative returns on investments.
Did you know the benefits of SIPs in mutual funds?
Review your investment portfolio
Deep market corrections or bear market is a good time to review your investment portfolio. In bull markets, riskier assets give high returns. As an investor, you are always happy with high returns and loath to sell assets which are giving you great returns. On the contrary, in pursuit of high returns, you may have increased your exposure to riskier assets like midcap or small cap stocks and funds, sector funds etc. These assets are likely to fall the most in deep corrections or bear markets. In bull market, we tend to view investments with rose tinted glasses, but a bear market should help you look at your portfolio from the proper risk perspective. You should know what you own in your portfolio and see if the risk profile of your portfolio is aligned with your risk capacity – take corrective actions if required.
Review your asset allocation
We have stated a number of times in our blog that, asset allocation is the most important part of financial planning. Asset allocation protects your investments from the vagaries of capital market and helps you meet your short term, medium term and long term financial goals. Yet, based on our experience, asset allocation is the most neglected aspect of financial planning in India - greed and fear is the primary reason. In bull markets, many investors go overboard with equities and take more risk than required, but in general risk aversion is the pre-dominant investment behavior of most investors in India.
Read more about asset allocation and market cycles
Asset allocation ensures that investors take the right amount of risk, not more and not less. There are several thumb rules of asset allocation, the most popular and still effective being the Rule of 100. Basically, you have to subtract your age from 100 and the figure you get, should be your equity allocation; the balance allocation should be in debt.
Read why you should not ignore debt funds
Asset allocation is not a one-time activity; you should review your asset allocation on an ongoing basis because different asset classes grow at different rates. So, even if you invested your money in proportion of your desired asset allocation, your actual asset allocation over a period of time can deviate substantially from your desired allocation. From time to time, therefore, you need to re-balance your portfolio, i.e. shift from equity to debt or vice versa. Ideally, you should rebalance your asset allocation once every year or once every two years. However, as discussed earlier, when the going is good, we tend to neglect asset allocation – it is human tendency. Deep market corrections or bear market is good time to think about your asset allocation and rebalance it, if your actual asset allocation has deviated from your target or desired allocation.
You may like to read simple asset allocation strategies for different risk profiles
Review your fixed income portfolio strategy
Deep market corrections or bear markets are often triggered by changes in interest rate outlook. In our view, your fixed income (debt investment) strategy should depend on your investment goals. If your investment goal with respect to fixed income is to achieve portfolio stability and generate steady returns, then low duration accrual based fixed income strategy is suitable for you. Such a strategy has relatively low interest rate sensitivity and gives your portfolio stability.
However, financial advisors sometimes advise investors to invest in long duration debt funds so that investors can benefit from favorable interest rate movements and get some capital appreciation. If interest rates are very low or they are expected to rise in the future, then investors should re-think their fixed income strategy because if interest rates (bond yields) rise, then long duration debt funds will give low returns. There is a demand supply mismatch for Government bonds in India now. FIIs are dumping Government bonds and the banks are not buying bonds. Government bond yields are rising and unless the PSU banks support Government bonds, yields will rise further, hurting long duration debt fund investors. Investors should review their fixed income portfolio and adopt a prudent strategy that gives their portfolio stability and generate steady income.
Did you know why long term debt mutual funds are underperforming short term funds
Meet with your financial advisor
If you are feeling nervous about the market and your investments, you should meet with your financial advisor and review your financial goals and investment plans. Some of you may be new to stock markets, but your financial advisor may have advised investors through multiple bear market cycles. A bear market tests the temperament of an investor; it also tests the qualities of a financial advisor. A good financial advisor is empathetic to investor’s needs, helps them remain calm and focused on their investment goals. Most financial advisors are very active in bull markets because selling mutual funds to investors is much easier in bull markets. A true financial advisor should work even harder during volatile markets and make sure that their clients are on the track of their financial goals, even during this difficult period.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.