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Taking Advantage of Volatility

The returns from equities for the last 1-2 years haven’t been great. The mid and smallcap category has taken a larger hit compared to large caps. The reasons range from US-China trade war, global slowdown, domestic slowdown, tight funding conditions, NBFC credit crunch, sharp decline in consumer sentiment etc. 

Now the key question is – will the markets fall further?

There are two ways to approach this problem:

Approach 1: Every falling market is different. You need to manage your portfolio based on your views of the fundamental event that has caused it.

This is extremely difficult to pull off in reality. Think about the major events which have hit us in the past – 2000 Dot Com Crisis, 2008 Subprime Crisis, 2011 Euro Debt crisis, 2016 China Crisis etc. And add to it other events such as Domestic Elections, Budget, Trump winning, Brexit, Fed Policy, Demonetisation, NBFC crisis etc. To evaluate each and every one of them correctly and predict how millions of investors will react to it, consistently is a tall ask.

Some of the best minds seem to agree.

“After nearly 50 years in this business, I do not know of anybody who has done market timing successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.” – Jack Bogle

“I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.”  – Warren Buffet

Now that predicting the markets in the short run, remains close to an impossible task, that leaves us with the second approach

Approach 2: All declines in the market are temporary and markets eventually recover. Equities go up in the long run and all declines are opportunities in retrospect. So all you need is a systematic process to buy equities when it falls.

Now with the humble submission that we won’t be able to predict the direction of the markets in the near term, this is a “Preparation” approach as against a “Prediction” approach. 

The idea is that, while we won’t be able to predict or forecast the next event which will impact the market, we can prepare by setting reasonable expectations and deciding on an action plan.

This is simply acknowledging that you’re pretty sure negative events which impact the markets will happen from time to time, but you’re not exactly sure when.

Why is it important to be clear on which approach to take?

When market correction starts, there is usually some negative event causing it. Intuitively, your mind will say that the markets will fall further. But you resist the lure. And then the expected happens – the market falls again just as your intuition suggested.

This point in a falling market where your intuition comes right in the short term is the most dangerous phase. You regret not having listened to your intuition. Your regret takes the form of – “If only I had sold earlier..”

You still resist the lure. The market falls yet again. Phew. You were right all along. Maybe you should have listened to your intuition. Your regret gets over you. This time is different. Let me get out now.

“When things improve I will get back”. You utter the most dangerous words during a falling market.

You have suddenly moved from your original view that “you can’t predict the markets” to “let me evaluate the fundamental event that has caused it and take a call on when to enter back”

Evidence is overwhelming that this approach usually leads to failure in handling a market decline as you need to get the timing right two times – entry and exit.

This is exactly why you need to make up your mind on your stance right now. This will be the determinant of how you handle market declines.

So how do we convert this “every fall is an opportunity” into an investment strategy? 

As the market fall continues, you get into the trap of constantly evaluating your portfolios and trying to make decisions on an as-and-when basis as new events/news/opinions keep bombarding us. Each and every time the market falls, the honest truth is that we really have no prediction capabilities to tell if the fall will continue or the markets will bounce back. So the key is not to look at each and every event/news/opinion as a reminder to take a decision.

In fact, the last thing we want you to do is to go unprepared into a falling market trying to take daily decisions based on the evolving events.

When it comes to decision-making, less is more and you need to reduce the number of decisions to be taken. Most importantly you need to have a clear pre-decided plan on WHEN and WHAT decision to take.

A simple plan might look like:

  1. If the market falls by 10% then I will…
  2. If the market falls by 20% then I will…
  3. If the market falls by 30% then I will…
  4. If the market falls by 40% then I will…
  5. If the market falls by 50% then I will…

This will ensure that you are better prepared to take advantage of the market if it falls further. Also, it serves as a reference to check how you thought you would behave during a fall (in your cool and calm avatar) vs how you actually behaved.

Do you have your plan ready?

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