Art of investing in falling markets

The index has risen by 81.9%, 40.5% and 55.7% respectively over the last three years. What does this translate into? An investor who had invested three years back would have made an absolute return of over 377% on his capital. A two year old investment would have grown by 197%. Of course a one year old investment would grow by 81.9% (the same as the index).

These are the index figures. Even a run of the mill equity scheme has outperformed these numbers. And in spite of this, we cannot take a 22% fall? I know, since the bases are different, the 22% actually translates into over 40%. Still in the light of the past returns, it isn’t as bad as the media makes it out to be.

The reasoning is simple. Over time, money chases earnings. In the stock market, corporate earnings alone are omnipotent. Nothing has changed in the span of a month to make our erstwhile blue chips fundamentally unsound. In other words, the index fall is not linked to corporate fundamentals. Corporate earnings will still grow at a healthy pace of 14% to 16% if not at the previously estimated 22% to 25% YoY. Which basically means that this is the minimum net return that an investor would get out of his investment over a period of time. Of course, barring short-term volatility.

Also, it’s a good thing that the correction, as it were, has come so fast, so soon. Further downside potential here on is limited. Even if the market were to fall to 7500 levels (worst case scenario), it means a fall of around 17% to 19% here on. Remember this is on a worst case basis. Chances are it won’t go that far.

However, no one has seen what tomorrow brings. Though it’s a question of when and not if, no one can say when the market will recover back to its earlier levels. It may take three months or six or even much more. But know that just like night follows day and day follows night, markets will rise and fall only to rise again. Money can be made and lost depending upon how you play the ball. Not keeping the eye on the ball and instead trying to play the situation is like trying to put handcuffs on an octopus. There are simply too many factors both global and local that affect the valuations and timing the same is a lost cause.

Instead invest regularly on the way up and on the way down. More importantly on the way down. There is also another very important benefit in investing on the way down. It helps you prevent a situation of having invested at the medium term peak.

Have a look at the following table :

Date	Units	NAV	Amount
18-May-06	6000	50	300,000
17-Nov-07	6000	60.23	361,360
Rate of Return			13.20%

The example assumes that a lumpsum investment is made on the 18th of May when the market is almost at its peak. After which it falls and it takes all of 18 months to recover. The NAV at the beginning is Rs. 50 and the NAV after 18 months is Rs. 60.23 (an absolute rise of around 20% overall of 18 months). The rate of return works out to 13.20% p.a.

Now, if the same investor, instead of investing at one time, had spread his investments over the period, the following would be the result.

Date	Units	NAV	Amount
18-May-06	1000	50	50,000
17-Aug-06	1111.11	45	50,000
17-Nov-06	1388.89	36	50,000
17-Feb-07	1207.73	41.4	50,000
17-May-07	1050.2	47.61	50,000
17-Aug-07	954.73	52.37	50,000
17-Nov-07	6712.66	60.23	404,281
Rate of Return			39%

Notice that the NAV steadily falls for the first six months of starting the investment. This will happen in a falling market. However, the investor has kept his investment amount constant.

After a fall of almost 28% (from Rs.50 to Rs. 36), the trend reverses and the market starts rising again and so does the NAV. After 18 months, it reaches Rs. 60.23 just like in the previous example. The total invested amount over the 18 month period is the same --- Rs. 3,00,000. However, the rate of return has jumped to 39%!!

Does your investment style belong to the first table or the second? Answer the question honestly to yourself. Throughout history, smart investors have recognized a fall in valuations as an opportunity to buy cheap. This fundamental principle never changes. To put it differently, it is the darkest before dawn. Its up to you to benefit from this darkness. The question is are you up to it?

How to build your MF portfolio?

Great salaries, excellent bonuses, fairly valued markets, high interest rates – the time looks just perfect to design and put together your mutual fund portfolio.

Building a MF portfolio is akin to building and furnishing your own home:

a) It depends on your financial capacity
b) Your personal tastes and preferences
c) Requires a lot of patience and care

Therefore, while there cannot be a model portfolio suiting everyone’s needs and objectives, you can follow a few general rules to build yourself one.

Be clear of what you want

To begin with, you must decide what your financial objectives are; and how much risk you are willing to take to achieve those objectives.

The goals should be as precise as possible. For example you goals could be

• Rs 50,000 to pay-off the personal loan in 2007
• Rs 2 lakhs for children’s higher education in 2012
• Rs 1 lakh for foreign trip in 2010
• Rs 7.5 lakhs for daughter’s marriage in 2015
• Rs 1 crore retirement corpus in 2020

Second, your goals must be realistic. They must be in line with your financial position and risk appetite. No point in having too ambitious or too pessimistic goals; or having goals, which require you to take undue risks.

Devote proper time and thought to planning your goals.

Done? Good, that’s a major part of your job over. Once you know where you stand and where you want to go, the rest is just a matter of details.

Match each goal with the appropriate MF category

Equity markets are too volatile in the short-term, but can give good returns in the long run. Debt funds, on the other hand, give steady but low returns. Therefore, select the goals, which you will finance through equity funds and through debt funds.

Assuming your retirement is still 15 years away, a predominantly equity portfolio may be a better option.

But for your personal loan, which is payable just one year hence, debt funds will be more suitable.

And for the medium term, like your foreign trip, balanced funds may be the right answer.

Liquid funds are a nice way to park your very short-term funds.

Don’t be too concentrated or over-diversify

Depending on the corpus, one could invest in an average of 4-7 funds for an equity portfolio and maybe 3-4 funds for the debt and balanced category. Too less a number of funds make your portfolio concentrated and risky. Too many, makes it unmanageable and doesn’t really serve the purpose. You need to strike the right balance.

Also, while selecting the fund, study their portfolio mix and ensure that they are different. If most of them are same, then even with 6-7 funds you won’t get the desired diversification.

In order to achieve diversification across asset classes, one could now look at some of the forthcoming options such as real estate fund, gold fund, international fund etc.

Build a suitable mix of equity funds

Apart from allocating your corpus in different asset classes, you need to do some allocation within the equity class. Index/Large Cap funds, Mid-cap/Small cap funds and Sector Funds are the 3 broad sub-categories in which you have to divide your corpus.

Index and Large Cap funds will deliver steady returns, which will be in line with the market performance. In the equity space, they carry lesser risk as compared to mid caps, small caps etc. About 70-80% of your corpus could be allocated to this category. They provide stability to your portfolio. Go for funds with moderate risk and consistent performance.

Your portfolio may need some kicker too. Mid-cap/Small cap funds and Sectors Funds have the potential to provide higher growth (of course with a higher risk). Be prepared for a bumpy ride; and sometimes crash landing too. A 10-20% allocation to this category may be okay. In case of a bad performance, major portion of your corpus is still relatively safe. Large caps will minimise your losses and will also bounce back quickly.

Don’t forget the tax aspect

Neglecting to pay tax is bad, but tax planning is not. It can help you to minimize your tax outgo, legally.

Therefore, take care to choose the right option – dividend payout, dividend reinvestment or growth. They may help you to save unnecessary taxes.

Make sure that you use the post-tax returns in your calculations. Else you may miss your target.

Having built a suitable portfolio, you need to nurture it. You have to regularly feed it with additional investments. You will have to remove the weeds (poor performing funds) periodically. And be patient. It takes time for the tree to grow. But once is has grown, it becomes strong – so you don’t have to take too much care; and fruitful – it will give you returns year after year.