Saturday, November 13, 2010

Volatility - the new Reality (Investing strategies for today)

When you invest in a piece of real estate close to your locality, where you think you understand the demand-supply dynamics, you are taking a bet on the future – that your plot of land will appreciate. This is an individual call and the returns that you may or may not get has no relation to the overall market, or with the national and international economy, at least to a large extent.


 The same argument applies to individual stocks; however, there is an additional twist here. However individual the stocks may be they do get influenced by the broad market and tend to move in concert especially in times of extreme volatility, more so  in case of stocks which form part of the index.


There are several institutional players in the market, all of whom are investing in the same basket of stocks and are being compared against the same benchmarks. The performance of all equity fund managers in India is measured on how well they performed vis-à-vis the Sensex , in one way or other. Hence they all have a huge incentive to try to second-guess the Sensex and to mirror its movements. Not doing that would be too much of a risk only maverick fund managers would be willing to take, and that too not for long, since their performance measures would tend to catch up with them.


I believe that when everyone is evaluated against a particular benchmark their performance will ultimately tend to follow the benchmark very closely.   There is a herd mentality that results in all institutional players behaving in the same fashion, and they control more and more of the money. It thus becomes a self fulfilling prophecy sometimes, sometimes a race to the bottom where everyone is vying to sell; and sometimes a euphoria-induced spiral to the top. The computer-based trading models worsen this situation since they could trigger off a one-way slide in case the markets steeply drop. FII inflows based on a commonly accepted "country-weightage index" only amplify the trend. As do cross-border money flows which results in disproportionate sums of money coming in or going out to move local markets across the world.


I still subscribe to the Benjamin Graham and Warren Buffett school of fundamental analysis, at least for old-economy stocks  – in the long run I believe "fundamentally sound" stocks will give good returns. But the long run is made up of several short runs; and the short runs are becoming more and more volatile. The performance of your equity portfolio today has a lot to do a lot with macro economic factors several of which have no direct relation to the company or industry of the company in which you bought the stock.


If we accept the above line of argument to be true, then our investing strategies need to change accordingly. The old fashioned "buy-and-hold for the long term" still works. In case you have picked your stocks well, it is a very good option to put your shares in a locker (that's only a figure of speech in these demat days!) and wake up once every few years to check the price. However, given that industry, economy, and company life-cycles are getting shorter nowadays, you may like to do that a bit more often just to ensure that your company continues to remain fundamentally strong.


While keeping the above strategy as the base, we should evaluate whether we need to modify it in light of the current situation. The way markets swing up and down nowadays, it is good to keep a close eye on the Sensex and take a call on the broad direction. One can never be fully right in this, of course, but we could take a position that, say, at today's 20k odd, the Sensex has some potential of upside with high volatility and risk; while with the Q.E.2, European crisis, etc. there is a significant risk of a steep crash that could be triggered off by some bad news.  Let's say the most likely scenario is that it will keep yo-yoing wildly in a band. Given this, would we want to shift some of our existing equity investments into debt or gold etf's and enter later, even if to buy the same stocks? It also has to do with the current outlook on gold and debt, of course. Gold has had a very good run in the last couple of years, and the upswing is showing no signs of reversal. Also, if there is a stock market decline due to some macro-related bad news like the US economy or Europe, there is every possibility that gold will go up still further. If one is unsure of both equity and gold, debt is of course a safe parking slot.


That implies of course that you should be able to switch between investment classes  with minimal cost. Some mutual funds do offer switch facilities – examine the costs of these options. I do not think this kind of switching should be done often; but there are occasions when you may take the call to switch. If you are invested in mutual funds, it is at least good to know switching costs in advance, and other things being equal, invest in funds that offer you this option at a low cost.


When markets were ruled purely by retail investors not acting in concert, investing for the long term without trying to time the market made sense. But markets are increasingly getting institutionalized. Market players are increasingly acting in concert. Euphoria is getting increasingly euphoric (for want of a better word). Panic is getting increasingly contagious. In such a situation, it is good to keep a macro-eye out and take a call sometimes and act on it.


I  welcome your views and comments.

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