Waiting for a correction to invest? Think again

With the Sensex scaling 18000, subprime now seems to be a distant bad dream. However it was not too far ago when investors across the world were running helter skelter hearing subprime. It was then that the Fed like knight warriors came to the rescue by cutting the interest rates by 50 basis points. This action seems to have wiped all the subprime mess that has taken several years to build up. What did investors do in the meantime? A lot of people waited, waited and waited for the markets to correct even further. Nobody dared to enter the markets at 15000 levels or for that matter even at 14000 levels. At the same time several pundits were predicting the next big correction. Well the markets in the meantime zoomed across and in the process most people missed the boat like always. Well the markets have a very high probability of correcting now but the moot point here: More money is lost in waiting for corrections, anticipating corrections than in corrections itself.

Waiting for corrections to happen has been a reality of the markets and all market participants are guilty of such practices. I am not saying it’s a bad thing but that short-term corrections and sharp up moves are very difficult if not impossible to predict. How many people would have predicted the 600-point rally after the Fed rate cut? Charles Ellis’s Investors Anthology has a very apt quote which was part of weekly staff letter (1951) of David Babson & Company “It must be apparent to intelligent investors who if anyone possessed the ability to do so (read - forecast the immediate trend of stock prices) consistently and accurately, he would become a billionaire so quickly, he would not find it necessary to sell his stock market guesses to the general public”

There are both rumors and reports that the Sensex will touch 20000 soon and 25000 in the next 6-9 months. The logic is that if China can be valued at rich valuations of 45 plus why couldn’t the second fastest growing economy valued at 25 or for that matter 30. Sensex company’s earnings are predicted to be around Rs. 860 by end of the current year and Rs. 1000 by 2009. What would be the index levels with such earning levels? Your guess is as good as mine on this one.

So what should people do in such situations?

1. Firstly rebalance your asset allocation and have clear investment rules stating rules on when to buy and sell. If you are high on equity and have made sizeable profits, it means move into cash or debt as per your investment strategy. After a correction, when you are high on cash you can move back into equity. However if you are low on equity, then you should stagger new investments on every fall. Now what happens if there are no falls? No market could be insulated against falls and there will be falls along the way. I am not sure how looking at forward or trailing PEs could help perfectly estimate overvaluation or undervaluation. It could be an indicator along with several other parameters including volumes, technical data and F&O information. But these are not sacrosanct parameters and more often than not, their interpretation is wrong. And by the way if there are no falls then you can only stagger your investments unemotionally through regular investments in stocks and mutual funds.
2. Wait for the significant correction to happen. This essentially means timing the market and this is again a very difficult thing to do. How do you know what is the lowest level and how long should you wait? Is the rally post the correction a realistic one or is it just a dead cat bounce? There are several questions to be understood and answered here and how many people are gifted enough to consistently get this exercise right. Warren Buffet is often quoted in almost every second column but few people have the habit of being patient. Finally what does being patient mean? In a structural bull run, how patient can a person really be with the index conquering new heights and whether it is a wise strategy.

Our market currently faces three key Risks

1. An untoward event in the global situation due to subprime or any other possible theory has the potential to bring markets down.
2. Increasing Oil and Commodity Prices might exert an upward pressure on inflation and interest rates.
3. Domestic Political Situation leading to an early election might also cause nervousness in the markets. However this is the least crucial of all risks as our economy has gathered the momentum to clock high growth rates with any political party running its affair (except for if the Left comes to power which at least in the current scenario looks highly improbable.

Indian Investors will be surprised to know that there are a lot of US Money Market Funds that have invested in subprime debt. Also there are several other financial institutions that have huge exposures to subprime debt. According to a recent Bloomberg column, AIG, the world’s largest insurer and reinsurer, had almost around one third (33%) of its USD 104 billion networth invested in subprime related securities. And there are several such insurance companies with subprime exposure of 3 to 20% of its networth. What would happen if one of these institutions or some large hedge fund with huge subprime exposures collapse like the one we witnessed in August this year? Surely our markets will come down and decoupling that is a buzzword these days might seem like a joke.

- Amar Pandit

The author is a practising Certified Financial Planner. He can be reached at amar.pandit@moneycontrol.com

The buzzword: Long-term equity investing

"Past performance is not an indicator of future performance" -- the literature of every mutual fund you own, mentions something to this effect.

In fact once, when I was lecturing at a mutual fund house, which was not performing well, one of the managers said, jocularly, “Can we say our past non-performance is not an indicator that in future we will not perform?”

And yet, ignoring the past in investing or in any other field is rarely a wise move. What we should understand is that the past is only a proxy for the future.

Wall Street stock investor, Peter Lynch sums this up well; he says“You cannot look in the rear view mirror and drive."

History is...history!

An important lesson from history -- you cannot learn from it!

We tend to over-emphasise the recent events of the immediate past, and worry about it. When you look at a fund performance, you will be guided by past history, the true to label portfolio selection, the consistency of performance and so on. However, if you chase performance on the basis of its immediate past, you are likely to be sorry.

There is enough literature to show that equities are an excellent long-term instrument, and very volatile in the short term. Equities outperform other asset classes, and vis-à-vis inflation.

In the Indian context if you had invested in the index, in say, 1978-79, and reshuffled it regularly (what an index fund would have done if it were available) your portfolio of Rs 100 would today be worth Rs 16,000.

This is an excellent rate of return, to hope for.

How to calculate stock returns

Studies show that stocks have returned about 19.2% per year from 1980 through 2006. This number however does not include the dividends reinvested. In the USA the dividend reinvested was twice the rate of appreciation.

Any return should be broken up into:

- Inflation

- Dividend

- Appreciation/capital gain

The buzzword: Long-term or average?

Think long-term. Does this mean that stocks have returned 19% per year in most years?

Hardly.

The volatility of stocks is legendary. Markets returned a figure as high as 266% in 1992 and followed it up with a 46% fall in 1993. Thus the word average return does not make any sense for a volatile asset class like equity.

Historically we have never had a four-year bull run! Three good years have been followed by one bad year – that is to say March 2008 has to end at a sensex figure less than that of March 2007.

But this is also an outlandish statement. Statistics are to be used very, very carefully, to analyse rather than predict.

Talking about average in equities is like saying: Yesterday the air conditioner was not working, today it is freezing. So, on an average we are comfortable!

But what's clear is that the probability of making losses is almost nil in case a person chooses a balanced fund, managed by a good manager (fund house), does an SIP and stays invested for say 10 years at least.

This wide disparity of returns makes holding stocks for long periods of time a better idea than holding them for short periods. So, where do we place our bets?

A thumbs down for this bond

If you are interested in steadier, more predictable returns, let's take a look at bonds, which tend to fluctuate less than stocks.

As a rule bonds cannot protect you against inflation. Let’s look at RBI bonds. It pays you 5.6% return (after tax) in a country where inflation is around 7%. That, effectively is a negative return of 1.4%.

When your advisor says, on an average you can expect to get 19% return over the next few years, what should you do? Baulk!

Predicting is difficult especially if it is about the future (Mark Twain).

Surely this 19% return is fine, but the total return on an equity share (therefore a fund) is a function of how much dividends you get, the inflation rate, and capital appreciation that you can expect. If your advisor does not know that, you need to read and equip yourself before meeting him!

Investment wishlist

a. For long-term money, equities remain the best investment.

They will not (perhaps cannot) return what they returned over the past five years. But other asset classes cannot be compared to equities.

b. Other asset classes like say debt funds protect your capital and give reasonably good returns. But they are not protected against inflation.

c. Well-diversified funds, index funds, unit linked equity funds (which by definition have a long term horizon) should all be in your wish list.

Morgan Stanley – the listed mutual fund available at a discount – should be a good choice too.

The final word: Manage your emotions (this may be the most important part of investing).

Lynch says: The amount of money you make is not a function of your IQ, but a function of the strength that your stomach muscles have!

Can you take a churn?

7-point action plan for Successful Investing

The financial markets turmoil caused by the sub prime issues in the US mortgages market is one more reflection of a grim reality of modern times...uncertainty is here to stay and the destabilizing impact on the markets has been increasing with time. Be it geopolitical tensions, natural disasters, asset bubbles and their consequent corrections, a host of events contribute to making the modern financial system extremely volatile. The global linkages of capital and investors mean that the correlation between geographies and asset classes has become stronger. Hence investors have to be smart and vigilant to ensure that the short-term mood swings of the markets do not unhinge their long-term financial plans and welfare.

So what is the prudent method to adopt in such times?

We have a 7-point action plan for investors:

1. Understand Yourself:
This is the starting point and is especially essential in such times. Start from the beginning - Assess your risk appetite, your time horizon and your financial goals. This will help you to understand if your current portfolio allocation is in line with your particular situation. In bull runs, the assessment of risk appetite gets inflated, while in bear markets, investors underestimate their ability to take on risks. Similarly, if you are investing for your retirement in 20 years as a financial goal, stock market gyrations over the next 3 to 5 years are irrelevant. After assessing these three parameters, look at your earning, saving and hence investment potential. Based on this you will have an idea of your ideal asset allocation...how much money to put in stocks, bank deposits, gold etc. And no better time than times of turmoil to spend a few critical moments evaluating what you have, where it’s located and where the holes in your investment ship may exist.

2. Understand the Risk Reward Equation:
So called safe investment options like Bank deposits, while giving steady returns, lead to erosion of purchasing power due to inflation and taxes both. At 5 % inflation, Rs 1000 today will be worth only Rs 230 in ten-year time. Over the last 27 years, while inflation averaged 7%, 1-year bank deposits, the most popular category, gave before tax returns of 7.5 %. Similarly, what costs Rs 1000 today, at 5% inflation, will cost Rs 1629 in 10 years time.

Stock markets give superior, inflation-adjusted returns, but in the short term they give a roller coaster ride. Hence its critical to understand the nature of each asset class, the type of returns, the risks associated with it and the optimal time horizon for them. If you are asking, “Is this a good time to buy”, you are on the wrong track. The question to ask is, “Will this investment / financial plan help me meet my long term goals?”

3. Understand Markets:
In the short term, stock markets are influenced by sentiments, while in the long run fundamentals are the key determinants. What is certain is that the stock market is a volatile animal, marked by euphoric highs and depressive lows. Indian markets have historically had a decline of 10% or more about once every two years. Even in the greatest bull market we have ever seen, from 2003 to 2007, there have been sharp declines. That's the nature of the market, even in good markets we have declines, and trying to predict its direction over the near term is an exercise in futility. Since 1979, we've had 18 corrections – or drops – of 10% or more. Investors who understand the fundamentals of the market don't panic or pull out when the cyclical declines take place.

4. Understand Long Term:
Over the last 28 years, the Indian stock market has yielded a compounded annualized growth of 20% per annum as reflected in the BSE Index, which has moved from 100 in 1979 to 17,000 in September 2007. Similarly, in 1992, from a market capitalization of Rs 160,000 crore, the Indian markets have moved up multi fold to a market cap of Rs 45 lakh crore in 2007. If in 1992, we knew our money would go up 28 times roughly in the next 15 years, all Indian investors would have put their entire savings in the stock market. However, we are happy in locking our money for 15 years in PPF accounts giving 8% assured returns. What is needed is an understanding that if you invest for the long term, i.e. for 10 years or more, the chance of making a loss is nearly zero, while the upside is many times that of other “safer” investment options. This understanding of what is truly long term is critical for financial health, and will lead to investors having peaceful sleep in times of high volatility.

5. Understand Diversification:
Diversification has and always will be the most critical component to investing wisely.

Keep funds equivalent to 6 months of expenses in a liquid fund or savings account. Use insurance to cover the risk of dying young, not as an investment vehicle. And diversify your investments into a wide range of equities, bonds, gold, real estate and other asset classes.

Consider gold and other precious metals. Historically, precious metals such as gold have been considered a ‘safe haven’ in times of economic, financial and geopolitical instability.

After you have covered yourself across the standard asset classes, all you need to do is to re-balance your portfolio on a quarterly basis and hang on tight. The bottom line is to have a well spread out, responsible plan for your investments and know what you own and why you own it.

6. Understand Time and Timing:
Remember that time in the market is important - not timing. Even diversified investment portfolios can lose ground in a bear market. At that time, it’s easy to be tempted to sell all your stocks and funds, and move to cash or bank deposits to wait for better times. All you have to do then, the reasoning goes, is move back into stocks on the day the stock market begins its recovery.

The problem is, nobody knows when that day will be. And if you miss getting back in at the right time, you can lose a huge portion of the upside. If you were investing at the highest point of the Sensex every year since 1979, you would have made around 19.6% compounded annual returns till 2007. On the other hand, if you were a financial wizard and invested at the lowest point of the Sensex every year since 1979, you would have made around 20.2 % compounded annual returns till 2007.

7. Understand SIPs: Invest in Bad Times and Good
One of the best ways to invest regularly is rupee cost averaging through a systematic investment plan or SIP. This involves investing the same amount at consistent intervals, such as once a month or every quarter. With this approach, you don’t have to try to guess which way the financial markets will move - and you won’t be waiting around for the perfect time to buy while the market gallops away. Even though SIPs can’t guarantee a profit or protect against a loss, they help you to take advantage of a down market by ensuring you end up buying more shares or mutual fund units when the price is down.

Market volatility is a fact of life, market decline are natural. By astute financial planning and asset allocation, investors can position themselves to ride out the waves towards financial security and success. This is as relevant in raging bull markets as they are in times of despondency. Following the above 7 Action Plan increases the odds of success manifold for the astute investor.

The author is CEO of Lotus India Asset Management Compan

Get your investment basics right NOW

Many a times we hear investors saying that they have investments in equity and mutual fund. Is this a correct statement? What is the difference between investing in equity market and investing in mutual fund? When someone says I have investment in equity and mutual fund it is like saying I am going to the plane and Delhi. Sounds weird isn’t it? How can some one go to plane? Plane is a vehicle, which can take us to Delhi, and Delhi is a city.

Somewhat similarly equity is an asset class while mutual fund is a vehicle, which helps us invest in a particular asset class. Through a mutual fund investor can invest in equity, debt or gold. To be a successful investor it is important to know the difference between asset class and investment vehicle.

Broadly there are two asset classes, financial assets and real or physical assets. Financial assets can be further divided into debt and equity. Similarly real or physical assets can be divided into real estate, bullion etc.

Financial Assets

Each of the assets has their own characteristics. When an investor invests in debt as an asset class he is playing a role of a lender. For example when we invest in bank fixed deposit we are lending money to bank. In return we earn interest. Debt based instruments have fixed maturity period. Upon maturity principal amount is given back to the investor. Usually debt as an asset class does not beat inflation. There is some exception to the concept of earning interest in case of mutual funds and traditional insurance policies like endowment, money-back and whole-life. In case of debt based mutual funds we earn in the form of dividend. Similarly in case of traditional insurance policies we earn in the form of bonuses. However debt mutual funds and traditional insurance polices earn by way of interest from its underlying instruments.

In case of equity, investor is playing a role of an owner – shared owner. When we purchase shares we share the ownership of the company. Returns from equity investing are in form of capital appreciation and dividend payouts. There is complete possibility of losing originally invested amount. In long run – over a period of 7 to 9 years - equity has potential to beat inflation as well as returns generated from debt. However in near term it could be highly volatile.

Real or Physical Assets

Real or physical assets are ones that an investor can look and feel. Real estate, bullion in form of gold, silver etc. are some of the examples. Here investor is complete owner of the asset class. His returns are mainly from capital appreciation. In case the investor has leased out real estate then there could be rental income from the investment.

Vehicles to invest in these assets

Financial wizards have developed various vehicles to invest in the above mentioned asset classes. Mutual fund is one such vehicle. Through mutual fund we can invest into debt, equity, gold and soon we will have real estate mutual funds. Similarly, investor can invest into insurance products. Traditional insurance products invest into debt. ULIP investment can be into debt or equity. It is important to note that currently in India expenses charged by investment oriented insurance products is extremely steep and hence they should “not” be used for investment. Portfolio management services could be another route to invest into debt, equity and even real estate.

Invariably it has been observed that investor intermingles asset class and investment vehicles. For example many a times investor says I have investment in equity and mutual fund. Similarly people treat fixed deposit and traditional insurance as separate asset class.

This kind of behavior proves detrimental while deciding overall asset allocation of one’s portfolio. While developing investment strategy first decide overall asset allocation based on asset classes. Having decided asset allocation choose investment vehicles which will optimise your returns from underlying asset classes.