3 investing thumb rules that can help you navigate next market crash better
India is a country where the terms of reference for many things in the game of cricket are set.
Can you imagine a team with only batsmen? Or a team where all the batsmen are like Virendra Sehwag or Chris Gayle, who always try to plunder bowling? Surely, the team’s interest was met by having a swashbuckling batsman like Sehwag, a genius like Tendulkar, a ‘wall’ like Dravid, or a stylist like Laxman?
In a team such as this, each player, great in his own right, was different from the other. That’s what made the Indian cricket team rise to such heights. Different styles led to risk reduction.
The same analogy can be used to explain investment in the stock market, or equity-oriented funds.
Of all the wrong impressions one develops about the market, one of the most enduring is the impression that success in the market calls for the brightest of brains, which can generate highest returns, and that achieving the highest returns is the ultimate measure of success in this field, or that complex-sounding products make more money than simple ones.
The reason for this strange situation is that in investing, “the best” is mistakenly defined as the product that has given the highest return in a specified time period (usually 12 months; sometimes shorter).
While there is absolutely nothing wrong in trying to excel (indeed, that is what a competitive field like the capital market is all about), the issue is that this ambition, while perfectly acceptable in normal times, turns quite dangerous in times when the market itself gets very skewed, or one-sided. The maxim that works well in normal times doesn’t work when the times are extraordinary, and the market periodically enters the realms of irrationality.
Under such circumstances, the ‘best returns’ are earned only in products that take on themselves high levels of risk – either in terms of sectoral concentration, or high valuations, or dilution in balance sheet quality.
Have not we seen companies with weaker balance sheets and dubious management quality outperform those with more stable and stronger balance sheets in wildly bullish market conditions?
Essential ingredients of any market bubble
Let us carefully look at any financial market bubble. We can conclude that each bubble is characterised by two essential ingredients:
(a) The insatiable appetite of a large segment of the market to invest only in ‘the best product’ – i.e., the one that gives maximum returns, and
(b) A money manager who claims or implies that he/she is able to deliver such returns
These two essential ingredients were seen in all financial market bubbles, be it in India and abroad. Records show such bubbles existed even in the 17th century (the Tulip bulb craze) and in the 18th century (the South Sea company bubble). We have seen these bubbles in the 20th and 21st centuries, and we’ll continue to see them.
So what does one do?
The first thing is to realize is that almost all investors will have lean periods (and they include professional fund managers). A couple of years ago, one study showed more than three-fourths of the ‘star’ fund managers spent three years out of a decade at the bottom of the performance table. Even the legendary Warren Buffett, considered to be the greatest investor of all time, has underperformed the index roughly one third of all years.
This is also corroborated by a study done by Motilal Oswal’s Wealth Management Team. It has established, through a study of several investment products over a 17-year period, that the chances that a first quartile product would remains in the first quartile in the subsequent year are only about 36 per cent.
A portfolio ‘outperforms’ a benchmark index only if it has a set of stocks that are different from the benchmark index. But there is no rule (manmade or divine) that says a set of stocks should move up immediately after we buy them, or begin to fall immediately after we sell them.
The second, and more important thing to realise is that a collection of ‘good’ stocks or ‘good investment products’, as opposed to ‘best investment products’ is definitely in each investor’s interest. Preferably, a collection of products that are different from each other, because similar products tend to rise and fall together, is in investor’s interest. A good financial adviser should definitely help in the choice of such products.
The third important point is the need to invest at regular intervals, and invest according to what is needed, and not according to what others might think. This seemingly routine stuff is often boring, but always invaluable.
(E A Sundaram is Executive Director & CIO-Equities at DHFL Pramerica Asset Managers. Views are his own. Investors are advised to consult their financial advisers before taking any investment decisions)