Stock market volatility: Common investing misconceptions during downturn; here's how you can protect your portfolio

Market volatility is an inevitable and unavoidable aspect of the stock market. It is a given that the market will rise or fall – it is a discipline which protects the investors from big losses. The key to successful long-term investing is preserving capital. Warren Buffett, arguably the world's greatest investor, has advocated one principle rule when investing – “Never lose money”.

One can always lose money in the stock market. It’s amazing how many people lose as opposed to winning when it comes to the market. Their main obstacles are fear and uncertainty. Fear to buy when they should and when they finally overcome this, they hesitate to have the conviction to buy. The best time to buy is when the crowd is panicking. Buy when fundamentally sound stocks are available at relatively cheaper valuations, and in the long run you will come out ahead regardless of stocks or mutual funds.

Once you go through this, you will be able to manage your portfolio in more effective ways and will avoid unnecessary losses that happen because of hope, greed, and fear.

Common investing misconceptions during a market downturn:

Find out a reason behind the fall: The share price may have dropped due to any reason but investors hold on because it is below the value to which they have anchored the investment. They cling on to hope that the price will revert to that level without assessing the fundamentals of the stock. If the stock price has dropped, find out the reasons for the decline. If there are justifiable reasons for the drop—such as lack of earnings visibility, a deteriorating balance sheet, corporate governance issues— it is better to cut your losses and exit.

Buying more to average: Everybody makes mistakes, but some investors tend to compound them. If the stock that you have purchased drops, don’t try to buy more shares to bring down your average buying price. Investors often try to cover their losses by buying more of the same shares at the lower price. There is merit in averaging down the price, provided the stock’s fundamentals are strong and the current drop is external to the company or owing to a temporary event. If your bet is right, the upside on the investment will be much higher. However, if the fundamentals have deteriorated, then averaging is like catching a falling knife; your losses will only worsen as you buy more of the same junk.

Representational image. Reuters.

Representational image. Reuters.

Falling for a confirmation bias: When their stocks go into a tailspin, investors start devouring investment news and research reports. But they also seek information or signals which support their beliefs and tend to ignore matter that refutes their original thesis. This confirmation bias works overtime during a falling market. It can distort your judgment of the situation and lead you to make a poor decision

Buy scrips at 52-week low prices: A sliding market turns some investors into value pickers. They actively look for stocks trading near their 52-week lows. These are perceived as good bargains since much of the downside is thought to have been already captured in the price. However, some of these ‘opportunities’ may actually turn out to be value traps. First, it is very difficult to pinpoint when a stock has bottomed out. As they say, the market can remain irrational for much longer than you can remain solvent.

Taking leveraged bets: Leverage can yield high returns, but also lead to big losses. This version of investing should be avoided at all times, particularly when markets are volatile. Taking leverage requires that the investment earns a return at least equivalent to the rate of interest you are paying on the borrowed capital. But with the high degree of uncertainty in stock markets over a short-medium term period, the investment may work either way. It may also bring emotions into play—if you are playing with money you can’t afford to lose, you may panic easily when the market dips.

Altering your financial plan: A sharp fall in the market can lead investors to alter their financial plan or investment strategy. Some may be tempted to excessively ramp up exposure to equities to benefit from the market correction, while the more conservative investors might deem it appropriate to take out all the money to be on the safe side. Don’t base your investment decisions or position the portfolio on the prevailing market mood. The future course of the market may work out completely different.

Stopping SIPs because of the fall: One common mistake that small investors make is to stop their Systematic Investment Plan (SIP’s) in equity funds when markets tumble. This defeats the very purpose of the SIP. A bearish phase is precisely the time when sticking to the SIP discipline will help you achieve your long-term goals. You will be buying more units at lower prices and reap benefits when the markets eventually rebound. Stopping the SIP will not only interrupt the compounding benefit of equities but also leave you with a shortfall in your target corpus. For those who have just started their SIP journey, it is even more critical that they remain invested for the long term and not get swayed by market sentiments.

Over-diversify the stocks portfolio: Mutual Funds diversify to reduce the risk, but individual investors usually bet big on a few stocks. Such focused exposure can hurt when the tide turns. At the same time, too much diversification also is not good. Some investors may try to reduce the risk by spreading their money across several sectors or even multiple companies within a sector at once. Sure, this will help you temporarily limit the downside and cushion your overall portfolio. But it will also prevent you from gaining meaningfully when the market recovers. Diversification is essential but beyond a point, it will not lessen the risks any further. Also, you will find it difficult to monitor a large number of stocks.

Strategy to preventing losses and accumulating quality wealth: It is not advisable to sell your investment holdings the moment they enter the losing territory, but you should remain keenly aware of your overall portfolio and the losses you're willing to endure in an effort to increase your wealth. While it's impossible to avoid risk entirely when investing in the markets, the following strategies can help protect your portfolio:

Diversification: As disciples, you should believe that a well-diversified portfolio will outperform a concentrated one. Investors create deeper and more broadly diversified portfolios by owning a large number of investments in more than one asset class, thus reducing unsystematic risk. This is the risk that comes with investing in a particular company as opposed to systematic risk, which is the risk associated with investing in the markets generally. Balancing is the key and this needs to be re-visited time and again.

Non-correlating assets: Asset correlation is a measure of how investments move in relation to one another and when. When assets move in the same direction at the same time, they are considered to be highly correlated. When one asset tends to move up when the other goes down, the two assets are considered to be negatively correlated. Stock portfolios that include 12, 18 or even 30 stocks can eliminate most, if not all, unsystematic risk, according to some financial experts.

Unfortunately, systematic risk is always present. However, by adding non-correlating asset classes such as bonds, commodities, currencies and real estate to a group of stocks, the end result is often lower volatility and reduced systematic risk due to the fact that non-correlating assets react differently to changes in the markets compared to stocks. When one asset is down, another is up. Ultimately, the use of non-correlating assets eliminates the highs and lows in performance, providing more balanced returns. At least that's the theory. In recent years, however, evidence suggests that assets that were once non-correlating now mimic each other, thereby reducing the strategy's effectiveness.

Options Strategies: Between 1926 and 2009, the S&P 500 declined in a total of 24 out of 84 years or more than 25 percent of the time. Investors generally protect upside gains by taking profits off the table. Sometimes this is a wise choice. However, it's often the case that winning stocks are simply taking a rest before continuing higher. In this instance, you don't want to sell but you do want to lock-in some of your gains. How does one do this?

There are several methods available. The most common is to buy put options, which is a bet that the underlying stock will go down in price. Different from shorting a stock, the put gives you the option to sell at a certain price at a specific point in the future.

For example, let's assume you own 100 shares of Company A and it has risen by 80 percent in a single year and trades at Rs. 100. You're convinced that its future is excellent but the stock has risen too quickly and will probably decline in value in the near term. To protect your profits, you buy one put option of Company A with an expiration date six months in the future at a strike price of Rs.105, or slightly in the money. The cost to buy this option is Rs. 600 or Rs. 6 per share, which gives you the right to sell 100 shares of Company A at Rs. 105, sometime prior to its expiry in six months. If the stock drops to Rs. 90, the cost to buy the put option will have risen significantly. At this point, you sell the option for a profit to offset the decline in the stock price.

Dividends: Investing in dividend-paying stocks is probably the least known way to protect your portfolio. Historically, dividends account for a significant portion of a stock's total return. In some cases, it can represent the entire amount. Owning stable companies that consistently pay dividends is a proven method for delivering above-average returns. When markets are declining, the cushion dividends provide is important to risk-averse investors and usually results in lower volatility. In addition to the investment income, studies show that companies which pay generous dividends tend to grow earnings faster than those that don't. Faster growth often leads to higher share prices which, in turn, generate higher capital gains.

In addition to providing a cushion when stock prices are falling, dividends are a good hedge against inflation. By investing in blue-chip companies that pay dividends as well as possess pricing power, you provide your portfolio with adequate protection.

You can thus protect your portfolio from falling stock markets through astute investment strategies and without resorting to any knee-jerk reactions.

(The writer is the Chairman of ABans Group of Companies)


Updated Date: Nov 01, 2018 17:27 PM

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