If you want good returns, you need to bear risks

Investing in bear markets requires three traits.The first trait, by rank, is to bear downside risk.The second trait is to think ahead, and the third trait is conviction.

Investors having two out of these three traits can also invest in bear markets, but the trait of bearing downside risk is of primary importance.

Bearing downside risk

Downside risk is the risk your investments will lose money due to a depreciation in value. In bear markets, investing in equities will have downside risk.

The risk differs depending on the security involved. The index (Nifty or Sensex) will have the least risk followed by large cap stocks, mid-cap stocks and small-cap stocks.

Certain levels in equity bear markets may look good in terms of many factors, including valuations. However, every level will be tested by the markets. For example, the Nifty may have looked good at 5,500, 5,300, 5,000 and 4,700.

Investors buying into the Nifty at 5,500 with a long-term point of view will hesitate to buy the Nifty at 4,700, as they have already seen a 15 percent depreciation on their investments.

The 15 percent depreciation is the downside risk the investor is taking when investing in the Nifty at 5,500.

Investors, unfortunately, do not see it that way.

They think that instead of making money, they lost money and that prevents them from staying invested or investing further sums of money at lower levels. It is a common investor trait and has no rationale attached to it.

The truth is, no investment will make money from day one. Markets, by nature, are volatile and there will be upsides and downsides.

In bear markets, investors will have to suffer downside risk when they buy, and in bull markets, investors have to suffer upside risk when they sell.

Hence investing in today’s markets, with the Nifty at 4,800 levels and the Sensex at 16,000 levels, with return expectations of over 25 percent will come with downside risk that the Nifty and Sensex could slide further by 10 percent.

Investors have to judge the downside risk they can bear. If they can tolerate higher downside risk, they should look at individual stocks, but if they are capable of only tolerating limited downside risk, they should stick to the index.

Bear market investments will always lose money first before giving higher-than-average returns.

Thinking ahead

Investors buying in bear markets need to have a vision of the future, and that vision should look bright.

If the vision does not look bright, there is no reason to buy stocks in bear markets as the investment will definitely turn sour before turning sweet.

The sentiment in bear markets is bad and there will be bad news before everywhere one looks. Investors will have to filter out negative news to look at the positives, if any, and then take investment decisions.

Today’s news is all about sovereign debt crisis, the fall in rupee, scams, corporate debt burden etc. Amid all this, sovereigns are pledging to cut their deficits, the Reserve Bank of India and government are acting against inflation, corporates are cutting costs, pruning debt and becoming productive, and investors are becoming more risk-averse.

All these are positives out of the negatives as they will strengthen economies and corporates down the line even as investors demand their price for investing.

Conviction

For sure, bear markets will test one’s conviction. Everyday, news will be bad, investments will depreciate in value at the blink of an eye, and there will be more reasons to sell rather than buy.

Bear markets, by definition, are markets where prices continuously fall. Usually, one can spot a bear market when prices have fallen sharply bringing down sentiment along with it. Investing in such markets require a lot of conviction about how the future will pan out.

The Nifty and Sensex are in the fourth year of a bear market and are at least 20 percent below their levels seen in late 2007 and early 2008.

Many stocks have lost more than 75 percent of their value in the past four years. Investors will need to have conviction that this bear market will not last for another four years before investing again.

A bear market turnaround happens without investors realising that one is taking place. Prices will first stagnate at lower levels before trending higher. Oversold markets will experience sharp rises from lows at first before stabilising, and then trend higher again as more investors spot value in stocks.

These are actually the first signs of a bull market and investors will need to have conviction to ride this initial bull phase of the market.

And bull markets behave the same way as bear markets.

Investors require to stomach a loss in profits to sell in bull markets. They also need to think ahead of potential risks on sustained gains in the prices of assets. The conviction to sell will be needed to exit bull markets.

Thinking back, if investors had these traits when the market was peaking out in 2007, a lot of money could have been saved.

Arjun Parthasarathy is the editor of www.investorsareidiots.com a web site for investors.