Equity: To be or not to be invested

A volatile market is a natural cause for concern. For one, individuals may fail to achieve their investment goal if equity prices decline in the year when cash has to be withdrawn from the portfolio.

For another, individuals with an investment horizon of more than five years would still be concerned regarding the downside in equity values during the investment period if such movement is beyond their loss-threshold.

The question is: Is it ideal to stay invested in equity during such market downturns?

This article explains individuals' risk behaviour towards equity. It then discusses how equity prices behave, and why it may be ideal to stay invested during the investment horizon despite market downturns.

RISK BEHAVIOUR

Risk profiling is an important component of the portfolio management process. This involves understanding the risk tolerance of the individual within the context of her current wealth, expected savings and the investment horizon.

As part of this process, the wealth manager typically quizzes the individual to understand her ability to assume market risk.

Two questions stand out in this regard. One, if the individual would rather be out of the stock market when it goes down than in the market when it goes up.

And two, if the individual would be in the market when it goes down than out of the market when it goes up.

While the answers to these questions no doubt capture the investor's desire to expose her investments to market risk, they also help manage the portfolio's within-horizon risk.

Consider the first question. If an individual's answer to this question is affirmative, it means that she is willing to sacrifice the upside potential to minimise her downside risk. And behavioural finance has shown that individuals typically regret choosing a loser more than failing to choose a winner!

This behaviour defeats the very purpose of investing in equity — its higher upside potential.

The point is such risk behaviour could prompt investors to stay out of the market for most part of their investment horizon because of the difficulty in forecasting market downturns!

And that could prove to be a less-than-ideal decision. What then should investors do?

UPSIDE VS DOWNSIDE

Individuals would do well to stay in the market when it goes down than be out of the market when it goes up!

Research has shown that missing the best days in the market can cause significant decline in realised return. Likewise, missing the worst days can significantly enhance the realised return. But the point is that investors can identify the best and the worst days only in hindsight!

It is, therefore, ideal to stay in the market and take profits based on pre-determined rules.

Consider this. We calculated the monthly returns on the Nifty Total Returns Index from January 2007 till November 2011.

Out of the 59 months, the index generated good returns in 29 months and negative returns in 30 months. And because this period included the market crash of 2008, the worst monthly return was -31.35 per cent, whereas the best monthly return was only 19.70 per cent.

This data seems to suggest that monthly losses are more than monthly gains.

If, however, an investor simply bought the Nifty Total Returns Index on January 1, 2007, and sold it on November 2011, she would have generated a holding period return of 24 per cent.

Of course, a holding period is sensitive to when an individual sells her investments; the holding period return from January 2007 to October 2011 would have, for instance, earned 34 per cent!

CONCLUSION

We are not suggesting that buy-and-hold investment is ideal.

Rather, we wish to point out that it is important to stay invested in the stock market at all times because market timing is difficult for most investors.

True, all individuals have a loss-threshold, beyond which holding the investment becomes difficult. A rule-based approach to investing and taking profits can moderate this pain and regret.

One way to do so is to combine the systematic investment plan with the systematic withdrawal plan on the Nifty ETF.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com )

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