Can you really predict whether the Nifty will top out at 11,500 or at 12,000? You obviously cannot.
Most investors and traders find it very hard to time the market. More so, when the market is behaving like a perfect roller-coaster! It is understandable in case of traders because the very nature of trading is quite risky. Unfortunately, this roller coaster approach applies to investing too. For example, we tend to get too enthusiastic about markets when the market is at a high and tend to get overly pessimistic when the markets are at a low. Effectively, instead of buying low and selling high we end up buying high and selling low. The illustration best captures this tendency.
The irony is that most investors end up buying heavily at the tops and end up selling out altogether when the market hits a bottom. This is exactly contrary to what we do with other products. In any bargain sale, you tend to rush for the lowest price but in case of equities the behaviour is totally different. Is there is a simple investment strategy out of this market rollercoaster? There is a 4 point model that you can follow to overcome this roller-coaster in the market.
1. Adopt rule-based allocation to equities
Can you really predict whether the Nifty will top out at 11,500 or at 12,000? You obviously cannot. Markets, by nature, are so unpredictable that it is hard to predict a level where the market can either top out or bottom out. The easier approach will be to adopt a valuation based approach. Let us take the P/E Ratio as the proxy for valuation here. For example, if you look at the past the Nifty has faced resistance above 25X P/E and has seen sharp correction around 28X P/E. You can structure your equity rule in such a way that your exposure to equities goes down to 30% by the time the P/E is 25 and further down to 15% by the time the P/E is 28. This will not only ensure that your profits are booked at regular intervals but will also ensure that you have liquidity available when better opportunities present at lower levels. The opposite rule will apply when the markets are falling. For example, markets have made a long term bottom around 11X P/E. You can position your investments accordingly.
2. Take on a phased approach to investing rather than try to time the market
A phased approach always works. You can worry about not doing well in certain conditions but we are talking about a period of 8-10 years when the market goes through a number of cycles. Under these circumstances, irrespective of the cycles, the phased approach will mean that you are better off in terms of costs and yields if you adopt a phased approach. The phased approach or the SIP approach will ensure that you are not required to time the market at all. In a roller coaster market, you will automatically get more shares when the market is low and will get more value when the market is high. When you look at it on a net basis, you would have done substantially better than a lump-sum approach.
3. Do you research and hold on to winners for as long as you can
You really cannot withstand a roller-coaster market unless you do in-depth research into a stock. Forget about tech meltdown, sub-prime crisis and 9/11. Stocks like Infosys and TCS have given very good returns through all these events. Identify a good stock and use every dip or sharp correction to accumulate more of the stock. A Hero Honda or Bajaj Auto is not like a Unitech. These stocks may go through down cycles and temporary problems. But their real strength lies in the robustness of their business models and their ability to handle the vagaries of the market. If you keep a small universe of stocks that are past performers, are growing and are industry leaders; then it is very difficult not to be right in such stocks. Just keep using dips to add more of these stocks.
4. Exit losers fast and never commit the cardinal sin of averaging
Buying the right stocks is one side of the story. The other side is not exiting the wrong stocks. There are two kinds of mistakes that investors commit. Firstly, they hold on to stocks in the hope that they will bounce back. For example, had you bought pharma stocks at the peak of 2014, you will still be sitting on big losses. As of now, there are no signs of the sector bouncing back, although it eventually could. A better way is to take a view that the stock or sector is in a sectoral downtrend and change your decision. Worse still, there are investors who keep averaging their loss making positions. This is tantamount to making the same loss multiple times. What the last two points summarize is that you must be a long term investor by design and not by default.
Markets are designed to operate like a roller-coaster. The best you can do is to follow the simple 4-factor model to make the best of this roller-coaster. You are likely to come out with flying colours!(The writer is Senior Equity and Research Analyst, Angel Broking)