The old adage that the market operates on greed and fear has been well-exemplified over the past few months. It is never savory to witness paper losses, and there are few fears as strong as losing one’s hard-earned money in a violent, abrupt market correction. In an environment where FIIs have been selling their wares at fire-sale prices to meet margin calls and recapitalization requirements in their home countries (or to simply avert bankruptcy), it may seem that the time has come to book losses, exit the market and re-enter at a more opportune time. However, there are several logical reasons why it does not pay to overreact…read on to understand why.
1. Market Timing never wins
A natural human reaction to a sudden plunge in the markets would be to run for safety by reducing or liquidating one’s exposure. The base instinct is to stem loss of capital and eventually re-enter the market at a more favourable juncture. However, repeated studies have shown that market timing, i.e. trying to perfectly time entry and exit points, seriously damages investor’s long-term returns. As the historical long-term trend of the stock market has been upward, one must recognize that there are significant risks with trying to accurately time the market’s peaks and troughs in search of abnormal gains. This strategy typically results in:
i. High exposure to stocks at the peak of bull runs (just prior to a sell-off), and
ii. A reduction of holdings in a deep bear market, just before of a period of stellar appreciation.
Essentially, timing the market puts one at risk of selling low and buying high, and is a sure-fire way of guaranteeing disappointing returns. Perfectly timing entry and exit points sounds good in theory, but usually fails in practice. The direction of the market can change rapidly, and market rallies can occur suddenly and over very short periods. Further, attempting to move in and out of the market can be an extremely costly affair, particularly because a significant portion of the market’s gains over time tend to come in concentrated periods. Missing out on just a handful of the best-performing days in the market may leave investors at a significant performance disadvantage compared to investors who remain fully invested for the long-term.
2. Markets Do Recover
First, one must recognise that no two crises are alike. The paths that each crisis takes, and the institutions they decimate, are always different. In the current scenario, what started out as a boiling over of the U.S. housing market and over-extended banks resulted in a chain-reaction across the globe, claiming victims in diverse places from Russia and Iceland to Argentina. Volatile markets are by definition highly unpredictable, and a case in point is the U.S. Dollar. While one would expect that the currency of the country suffering the most would fall in value rapidly, the reverse has happened. The phenomenon of de-leveraging and unwinding of global assets by FIIs has resulted in huge demand from them for U.S. Dollars to repatriate back to their home countries.
The ensuing liquidity crisis in India, coupled with negative psychology and sentiment, has resulted in tight credit conditions across the economy. But history shows us that corporations learn to tighten their belts, governments induce liquidity and confidence-building measures, pricing re-discovery begins, and eventually the tide turns. Declines in the equity markets are not uncommon, and as mentioned previously, such periods of sudden turmoil have been normal occurrences in the market’s long-term upward trend.
3. Emotions ? Wealth Creation
Fleeing stocks for the safety of Gilts or CDs or Liquid Funds may seem quite appealing at times, especially when the market takes a sudden plunge on a negative news headline. In times of turmoil, it can be difficult to take a long-term view and resist the urge to react to the latest market swing. For short-term financial needs, cash and cash-equivalent investments can be good choices. However, they are not suitable for long-term wealth creation, because the returns are likely to be too low – your investments need to outpace inflationover time, otherwise your purchasing power is eroded. Historically, it’s been equities that have helped investors compensate for inflation by delivering higher average annual returns than cash or debt investments.
The need to keep an investment allocation policy constant is thus necessary for wealth accumulation. One can always alter the allocation to meet changing lifestyle needs and requirements, when it makes sense to revisit your investment plan due to meaningful changes in your life – the change should be driven by something significant and permanent. On the other hand, booking losses or making sudden, abrupt changes in line with market declines would not get you where you want to be. Keep in mind that 21st century technology and medical science advancements may help you live 80, 90 or even 100 years! With extended investment horizons the effects of inflation and the preservation of purchasing power need to be seriously considered. Staying calm can help investors avoid making moves they later regret. And emotional decisions more often than not lead to regrets.
4. Crisis = Opportunity Scale UP, not down!
To paraphrase the old sage of the markets, Warren Buffet, when others are fearful it is time to be greedy and vice versa. As painful as they are, market downturns can serve as reminders of the risk inherent in the market. It is precisely because stocks are a volatile asset class that they have historically provided a higher rate of return relative to other major asset classes, such as debt or cash. Market participants expect higher returns to compensate them for taking on additional risk. As a result, market fluctuations are the norm and not the exception, and short-term fluctuations are inevitable in the long-term upward trajectory of the market.
That is why some of the best periods to have entered the stock market have been during periods of particularly negative sentiment and extreme market turbulence. Hindsight suggests that during challenging economic episodes in history, investing more in stocks has been a prudent decision. While having the fortitude to stay invested provides an opportunity to fully participate in the market’s long-term upward trend, investing additional money has proven to be the kicker that can generate large returns in one’s portfolio. Waiting until sentiment feels positive again to make an investment has typically not been a good method of achieving future returns. Many of the best periods to invest in stocks have been those environments that were among the most unnerving.
5. Technicals vs. Fundamentals
When market technicals and perception start overriding the fundamentals, the question we ask is how is it that a large, blue-chip corporation is suddenly worth 20% or 30% less than a week ago or a month ago? Is the sell-off justified by the underlying economic and corporate fundamentals? Is the market becoming too pessimistic? Or is the sell-off in line with diminished expectations for economic growth, profitability and balance sheet performance in the coming months?
Whenever panic-induced selling begins, prices can become much cheaper than justified by their intrinsic value. This is the reverse of what typically happens in a hyper bull-market run. Valuations can become irrational on both the up-swing and down-swing. This is no doubt a tremendously challenging time for investors, but panics can cause prices to fall further than might be appropriate based on the underlying fundamentals. While nobody has a crystal ball to predict when exactly the bear market will turn around, you can be assured that as long as the entire world’s economy does not collapse overnight, it is low valuations that will eventually set the stage for the next bull-market rally.