Should investors resist the temptation to exit equities now and return later?

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Indian stock markets have fallen over the past few months, driven by several concerns: high inflation around the world, rising interest rates from global central banks (including the Reserve Bank of India), war between Russia and Ukraine, high crude oil prices, lockdowns in China due to rising covid cases, global supply chain constraints and huge outflows from Foreign Institutional Investors (FIIs) of Indian stocks , etc.

Given the recent decline in the markets and several uncertainties, it is natural for many of us to extrapolate the current situation and fear that the fall will continue. There is a strong natural temptation to exit stocks now with the intention of returning to them at lower levels later. While this approach seems logical, unfortunately there are counter-intuitive patterns (read traps) that occur during a market drop that make it extremely difficult to re-enter the markets once you’ve sold.

Here are the five counterintuitive patterns to watch out for.

Model 1: Stock market recoveries usually occur in the midst of bad news.

It’s hard to time your entry, as history tells us that stock markets usually bottom before the worst news arrives. The recent Covid 2020 crash was a classic case where Indian markets rebounded 40% before actual covid cases peaked in the first wave. This is a trend seen in most bear market rallies, both in India and globally.

Figure 2: A market decline has multiple false upside bounces and the actual rally also has multiple false declines.

There are a lot of false bull rallies in the middle of a market drop. Once you encounter several false bull rallies in the midst of a market drop and add the persistent bad news to it, chances are you will dismiss the actual rally as another false bull rally. To make matters more confusing, even the actual rally has a lot of intermittent false declines. As a result, it is very difficult to distinguish between the real recovery and the fake bullish rally.

Model 3: Recovery is usually extremely fast.

Waiting a few months (say about six months) to confirm a rally (as opposed to a false rise) also doesn’t work well because most of the time the initial rally is extremely quick. Case in point: the Sensex gained 85% in just three months during the 2009 recovery.

Model 4: We anchor ourselves psychologically at the lower levels.

Once you miss the bottom of the market, you are usually psychologically anchored to the lower levels and it is behaviorally difficult to return to higher levels.

Model 5: No one can predict short-term markets.

Even the best market experts cannot predict exactly when a market rally will occur on a consistent basis. There are several changing factors that impact the markets in the short term and it is difficult to predict how millions of investors will react to this. If you plan on waiting for your favorite market expert to let you know when to come back, that might not be a good idea.

All in all, while easy to get out of, these five counter-intuitive patterns along with the fact that short-term market movements are hard to predict consistently make it extremely difficult to time your entry if you get out now. . A temporary downside, though no doubt painful, is the emotional costs that equity investors must pay to achieve superior long-term returns. As we mature, our approach to market declines becomes one of acceptance rather than denial.

The best course of action will be to stick to your initial plan, i.e. your asset allocation between stocks, debt and gold. If the market decline continues, continue to rebalance your original asset allocation (i.e. increase equity and decrease debt/gold) at regular pre-determined intervals.

The boring but proven mindset needed to invest successfully remains the same: stay patient (keep a time horizon of at least 7 years), be humble (don’t try to time the market), be ready (to endure temporary market dips) and remain optimistic for the long term (belief in human ingenuity).

Arun Kumar is Head of Research at FundsIndia.

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