4 ways to ace falling markets

[K.Karthik Raja]

4 ways to ace falling markets

April 14, 2008 09:10 IST

Investing in rising equity markets is always easier than investing in
falling markets. Since a rising tide lifts all boats, rising equity
markets can make even mediocre investments appear like great
investments. But when markets collapse like they did earlier this
year, many of these 'great' investments suddenly start appearing like
great mistakes. Nonetheless, there are lessons to be learnt from
falling markets and we have a 4-step strategy on how you can ace
falling markets.

In rising markets investors are usually exuberant and expect markets
to continue in the same vein. This is when most investors make
mistakes. Two of the more common investment mistakes are 1) investing
mainly in equities (i.e. lack of diversification) and 2) add to
existing equity investments which results in lop-sided asset
allocation (i.e. perilously high allocation to equities).

A lot of investors fail to realise that markets do not tread in one
direction for ever. Stock markets are characterised by ups and downs,
which is commonly referred to as market cycles. And often, markets can
take a sharp U turn. Although, the warning signs are there, investors
usually choose to ignore them or don't read them well enough. And when
markets turn, the higher equity allocation can appear like the most
burdensome thing in the world to the investor.

At Personalfn, we have maintained that investors must aim at building
a well-diversified portfolio which can prove resilient enough over
various markets cycles. Here is a simple 4-step investment strategy to
protect your finances in falling markets.

Diversify your investments
Diversification simply means spreading your investments across various
asset classes such as equity, debt, gold, cash and real estate. A well-
diversified portfolio enables investors to protect their wealth during
a market downturn.

The two biggest advantages of diversification are 1) it reduces the
overall risk of the portfolio and 2) it improves its performance over
longer time frames. In an adverse scenario, diversification ensures
that only a part of the portfolio is impacted leaving the rest
relatively unaffected.

To understand this better consider the mad rush for gold ever since US
markets were hit by the sub-prime crisis. If investors had pursued a
well-defined asset allocation plan they would have invested in gold
before the market fall.

This would have helped them in two ways a) they would have benefited
from rising gold prices and b) since equity allocations were capped at
pre-defined levels, losses would have been lower.

Invest further
Falling markets enable investors to critically evaluate the mutual
funds in their portfolios and identify the ones that have performed
well over a market cycle. These are the funds that deserve your money.
So use falling markets to add to these investments.

In rising markets, there is a fair chance that you would have invested
at a higher NAV (net asset value). Now in falling markets you have the
opportunity to make additional investments at lower NAV to lower the
average cost of your investment.

Identify the flaws
Not everything about falling markets is awful. Falling markets can
prove a point; they can identify the flaws in your portfolio. Flaws
like thematic funds and thoughtless NFOs (new fund offers) for
instance, that never should have been allowed inside your portfolio in
the first place. Identify these flaws well and at the next opportunity
(read market upturn), get out of them.

Start your tax-planning
Last but not the least, start your tax-planning. To most investors,
tax-planning is considered as an end-of-the-financial year exercise
and therefore relegated to the bottom of the investment 'to do' list.
We maintain that tax-planning is an integral part of financial
planning so when markets fall, make the most of the opportunity to
invest in tax-saving funds/ELSS (equity linked saving scheme) assuming
you have the risk appetite for equities.

If you wait for the financial year-end to begin investing, you may not
necessarily get the opportunity to invest at lower levels, especially
if markets are in recovery mode.

[K.Karthik Raja]

4 ways to ace falling markets