A few days 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, present good buying opportunity. Market downturns also help him identify the solid performers and replace the relatively weak performers with the solid ones. Unfortunately most retail investors are not like this investor. In fact they do just the opposite. They get exuberant in bull markets and panic during corrections. If you belong to this group, remember it is natural human emotion. In fact, runaway bull and bear markets are caused by irrational exuberance and panic respectively. As an equity investor you should not be afraid of volatility. In this blog, we will discuss some rules to manage your investments in volatile markets.
- 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. However, it 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. In psychological terms this is an attribute of emotional intelligence. You should understand the inherent characteristics of equity as an asset class. Volatility is an inherent characteristic of equities. Your investment may lose its value in a market downturn, but remember you still own the asset. Once you ride out the volatility your asset will again appreciate in value.
- Corrections present a good opportunity to invest, because you can buy assets at a relatively lower valuation. The recent market correction, thankfully it is over for the time being, had a few worried investors calling their brokers. However, the good thing about this correction was that, while FIIs sold, domestic investors bought in the market. If you have invested in mutual funds during this correction, you would have bought your units at 7% lower cost compared to the peak. The sharper the downturn, the better is the buying opportunity. Systematic Investment Plans (SIPs) is a great investment mechanism because it can help investors to take advantage of volatility by averaging out the cost of the units purchased. SIPs help investors stay disciplined during volatile markets and help you achieve your investment goals, irrespective of what the market is doing in the short term.
- Do not forget your asset allocation during volatile market conditions. Your asset allocation is governed by your risk tolerance and financial objectives. Run away 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 equity or shift from debt to equity depending upon your financial situation.
- 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 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 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.
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.