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How to manage your equity investments

Dhirendra Kumar

After the market shot throught the roof recently, it is time to review what it takes to make equities work harder. This frenzied market rise was after five years of market depression. After a period during 1994-1999 when returns from the stock market were most depressing, it was perhaps understandable that most investors focused on the risk part of the Risk-Reward Equation (high risk = high rewards).

And if the market sustains its momentum, the reverse will be true when investors tend to go overboard on equities. It is at these times that you should understand how to manage your equities, and the risks and rewards of investing in common stocks

This article is intended to help put stock market valuations and returns in historical perspective and provide some prudent guidelines for individual investors.

The Stock Market Is Volatile:
Over the long-term (based on a 20-year Sensex performance), returns provided by common stocks have averaged over 20 per cent annually. But this average return masks a great deal of volatility because returns have fluctuated within a very wide band. Over the past eight years, the Sensex has provided annual returns ranging from a low of negative 24 per cent (in 1998) to a high of 91per cent (in 1991).

This extreme volatility is the principal risk of investing in equities.And it stays in investors' memories long after stock prices have crashed. The best way to manage this risk is to invest for a long time frame. Time greatly reduces, though it does not totally eliminate, the volatility in returns from stocks.

One can draw at least three conclusions from long-term equity trends. Firstly, time reduces the risks of holding equities. Secondly, there is no guarantee that you will earn the long-term average of 20 per cent a year even if you hold stocks for two decades or more, as this is a historical return. Lastly, years like 1990 and 1991, when the Sensex provided total returns of 33.82 per cent and 91.03 per cent respectively, may already have provided a sizable chunk of the returns that can reasonably be expected over the next several years.

Bear Markets Are Part of Investing
Investors who are relatively new to investing in equities may benefit from some perspective about bear markets (a prolonged period of falling prices). Although no one can reliably predict the timing of bear markets (or bull markets for that matter), a prudent investor should understand the extent to which stock prices can decline and should be prepared to "ride out" these periods when they occur. The big danger from bear markets is that an investor will sell at or near the bottom of the downturn.

Reasonable Expectations or Surprises:
Investment returns from equities over short periods (sometimes even periods of several years) are notoriously unpredictable. Which is why you should rely on long-term historical averages in setting their expectations about future returns. While these long-term averages do not predict short-term results, they may provide some clues for what investors might expect over longer periods, such as the coming 10 to 15 years.

In recent years, the stock market has provided investment returns that is far below the long-term average. Some measures of stock market value indicate that stocks are currently cheap compared to long-term historical averages. No one knows whether stock valuations will move back toward their long-term averages quickly or slowly, or even when such a trend might begin.

Generally, there is considerably lower risks of investing in equities, especially when stock prices are low by traditional measures of value such as price/earning ratios and dividend yields. I am not attempting to predict the direction of the stock market. Instead, I am suggesting that the risks of investing in equities have been reduced in recent years along with the sharp fall in stock prices. Prudent investors will consider the stock market's low current valuations in forming expectations for future returns and in planning their personal finances.

How to Manage Risk:
Although risk is inescapable when investing in common stocks, perhaps the greatest risk is that you will never invest in common stocks because you can never be sure when is "the right time" to invest. Uncertainty is a permanent feature of the investing landscape.Trying to discern the ideal time to invest in stocks is almost always a futile exercise.

Investors are better served by using time-tested strategies for managing risk. The following precepts have been used to good effect by successful investors in all sorts of investment climates.

Know Thyself:
Over periods of a decade or more, stock prices are determined mainly by fundamentals such as corporate earnings, dividends, and interest rates on competing investments. However, emotion can rule the market over periods lasting even several years. Successful investors acknowledge the presence and power of emotion and try to understand their own investing psychology. Can you take it in stride and not become excited when the market provides big returns and avoid panic in the midst of a sharp downturn in stock prices?

Keep Your Balance:
An investment portfolio should be developed by balancing the risk characteristics of stocks, bonds, and cash investments against the returns you desire from your portfolio. In some cases, you may want a portfolio that consists of only one class of assets, such as stocks. In other cases, you may want to include in your portfolio more than one type of asset, for e.g., stocks and bonds in order to reduce risk.

Patience:
Time mutes the risk of holding stocks. By riding out the inevitable bear markets in stocks (thus avoiding the temptation to sell when prices are down and the sentiment is gloomy), you enhance your chance of achieving solid, long-term returns. History suggests that the longer the holding period, the less likely an investor is to receive negative returns from common stocks. It also shows how severe losses from stocks can be over relatively brief periods.

Tune Out Market "Noise":
Don't be swayed by market fluctuations or the cacophony of opinions and predictions from market analysts and forecasters. Your investment strategy should be based on your personal objectives, time horizon, risk tolerance, and financial circumstances. It should not be determined by the direction of the financial markets or the opinions of "the experts".

Take Your Time:
If you have a large sum to invest in stocks or bonds, do not feel compelled to do so all at once. Similarly, if you decide to sell a portion of your holdings, plan to redeem shares gradually through a regular series of transactions. This strategy of rupee-cost averaging can substantially reduce the risks of investing.

If you are in a state of anxiety about the markets, "sell to the sleeping point." I recommend that you do not make large, abrupt changes in the strategic asset allocations that you had determined were right for you. Rather, limit the changes in your portfolio allocations to 10 or 15 percentage points. If you have 65% of your assets in equity funds and feel too nervous, reduce the allocation to 50% or 55% of your portfolio. But don't abandon any type of asset. Keep in mind that investing is a long-term voyage and that the best decision most investors can make is to develop an investment strategy and goal, and then maintain a steady pursuit of that goal.

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