What advisers can teach clients about market cycles

It is very tempting for clients to be in the next best investment and one often regrets missing out on something.
By Guest |  01-03-17 | 
 
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“Should I exit equity funds?”

“Should I buy equity shares through premature withdrawal of my money from bank deposits?”

“Should I sell out of my mutual funds to invest in a property?”

As an IFA, these are some of the most common and regular questions that you must be facing. The frequency and number of such questions go through the roof especially when at least one asset category is on fire or is down in the dumps.

A peep into the history

History is replete with such examples of investors moving from one extreme to another. Time and again, investors have moved in droves abandoning one asset class and jumped to another.

Roughly twenty-five years ago, when the Indian economy was at the brink of a disaster with forex reserves almost nil, reforms were initiated by the then government. Suddenly, equity was the flavor of the day and investors started flocking into equity markets with whatever money they had. The year 1992 saw huge amount of inflow of household savings into equity markets. As per the report of the Reserve Bank of India, that year saw a whopping 24% of household savings coming into capital markets. We haven’t seen such flows before or ever since.

In the subsequent market crash, many investors moved lock, stock and barrel out of equity assets.

Later in 1996-97, we saw a huge rush for company fixed deposits as the interest rates reached a peak. NBFCs, especially, were the darlings of the investors. By 1998-99, many of these companies had failed to return the depositor’s money in time.

The equity markets had started looking up at this time, led by the information technology sector. This was the time when the Internet was entering our life and was expected to change the way we lived. By late 1999, the stocks of technology companies were virtually (pun intended) flying. The prices were soaring through the roof. Indian investors found a new and completely unknown future. It was a no-brainer and money started flowing into the technology companies. Many started breaking their bank fixed deposits to buy these “hot” stocks.

On 11th September 2001, the world witnessed an unbelievable event – the attack on the twin towers at World Trade Centre in New York. The subsequent fear resulted in the investors panicking out of equities and towards the safe havens of fixed deposits.

The years through 2004-2007 once again saw a rush towards equity and that too towards certain sectors related to infrastructure.

When this sector and along with it the whole equity market crashed, we saw investors shunning their SIPs into equity funds to rush to buy gold and gold funds.

This mass-scale shift from one asset class to another is not new and this keeps happening from time to time.

While investor psychology is difficult to understand, it is important for an IFA to understand the same. A good IFA would also watch his own behavior to understand and ensure that one does not fall prey to the same biases that a typical investor suffers from. These biases lead one to shift completely in or out of an asset category.

Why do people resort to such shifts?

First of all, many investors do not understand that the factors impacting the short term price movements are very different from those impacting the long term movements.

Next, their short term thinking is driven in part by the emotions of greed and fear. While greed makes them take undue risks and shift entirely to riskier assets; fear drives them towards the safe havens.

These two together make them forget that market prices of most securities would move in either direction based on the opinions of a large number of people operating in the respective market.

Is there a problem with such a behavior?

So what is wrong with such a behavior? There is no problem so long as people are making money. In order to make money, the investor needs to be in an asset class before the rally starts and out of it before the prices crash. The reality, however, is far from it. Most of the time, the investors are out of an asset after a crash and enter one after the prices have gone up.

Let us look at some instances here:

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(* Average of high and low for the month)

The above table shows the net inflows in Gold ETFs against gold prices for the month. For the sake of simple illustration, we have shown only the average of high and low prices for the month.

As can be seen, in December 2012 and January 2013, when the gold prices were in the Rs. 30,000 range, the investors were buying units of Gold ETFs. However, in July 2015 and December 2015, there were net redemptions when the gold prices had come down to the lows of Rs. 25,000. What this means is that investors were buying gold at high prices and selling it at lower prices.

Though, this is just one example of such a behavior, there are numerous instances when investors have tried to take a view on the movement of market prices and bought high and sold low in the process.

In order to be right, one has to get the timing correct. If you can, there is no better strategy. However, the numbers above as well as many other instances suggest otherwise.

While all the above discussion seems like it is about the investors. However, very often, even the IFAs also get carried away by the noise and the emotions of greed and fear. In such a case, even your advice may get colored.

There are few things that lead an IFA to swing from one extreme to another:

  1. Temptation to showcase one’s expertise:

Investors come to an IFA in search of solutions to their problems related to money and investments. What kind of problems can you solve? What is your expertise? It is very easy to highlight the performance of an investment as one’s expertise. The truth is: is that really the IFA’s expertise that resulted in superior investment performance? Can the IFA control the performance of an investment avenue or a portfolio?

It is a must to showcase your expertise. However, the first step before that is to know what your expertise is.

Check your track record. If you are expert at generating superior portfolio performance, please measure the performance of your advice and showcase it. If not, think what your expertise is.

  1. Getting swayed by the mood of the markets:

Humans are social animals and hence it is quite common to go with the crowd. We have often seen this behavior playing out in the financial markets when certain decisions are taken only because these are popular at that point of time. Some of the numbers we shared earlier are testimony to this. It was fashionable to buy gold in 2012 and it was fashionable to invest in infrastructure stocks in 2007-08.

Many IFAs also get carried away and recommend investment avenues that are popular at that time. These are not necessarily the best. However, the truth is revealed only later.

This is a high-risk strategy. It has the potential to generate huge returns for the investor, if you get it right. However, if you get it wrong, the margin of error is very small. The investor loses money and in turn, faith. With loss of faith, you lose clients.

As an IFA, one has to understand one’s strengths and limitations. The business must be built around your strengths, and within the limitations. Can you predict the next move of any of the financial markets? Will you be able to correctly predict the next drop in interest rates? Will you know when the stock prices would start rising or falling? And in which sector?

What is the option if you cannot predict?

Diversify.

Sir John Templeton has said: "The only investors who shouldn't diversify are those who are right 100% of the time."

Consider diversification across asset categories apart from company wise and industry wise diversification. The diversification across asset categories would be done in line with the needs of your clients. Such a diversification is good for both – the investor as well as the IFA.

Please remember, diversification would not stop the sharp market movements in either direction. It would only help stabilize the movement of the value of the entire portfolio for the client and that of the book of business for the IFA.

It is very tempting to be in the next best investment and one often regrets missing out on something. However, prudence suggests that while extremes may happen, most of the life is lived between the extremes. It is in this context that an IFA must consider having a multi-asset portfolio. Such a portfolio would mean including different asset categories in your recommendation list. The recommendation list may consist of equity mutual funds, stocks, debt mutual funds, debentures, bonds, company fixed deposits, liquid mutual funds, etc.

Some basic investment truths

Let us understand some basic truths:

  • Asset prices are expected to go up in future

This is commonsense. If the above statement was false, there was no point in investing in any of the asset categories that was not expected to see price rise in future.

  • Asset prices are cyclical and unpredictable

Prices of various asset categories move up and down periodically. Very often these price movements are highly unpredictable and inexplicable in the short term.  We are quite familiar with the price movement in equity markets since these prices are highly visible. However, the same is not so visible in the debt markets since most of the retail debt investments are either non-marketable (e.g. post office saving schemes or bank fixed deposits or company deposits) or the market prices are not tracked regularly.

However, if we look at the changes in interest rates, we see that the rates do not remain constant for long. This change in interest rate represents the change in the price of investments. Such changes are also highly unpredictable.

  • The cycles are different across different asset categories

Another important truth is that the price movements across different asset categories do not move together. This means that the short term fluctuations of one asset class get cancelled out by another, or at least the impact is reduced.

Very often we have seen that when the equity shares are going down, the fixed interest coming from debt instruments acts as a cushion. At the same time, if the share prices continue to fall for long, the reason often is the slow down (or downtrend) in the economy. Such a downtrend is controlled by the Reserve Bank of India through reduction in interest rates. Such reduction in interest rates increases the prices of existing bonds and hence the NAVs of debt mutual funds.

Similarly, when the economy is doing very well, the share prices are going up. At this time, inflation also starts to move up. In order to curb the inflation, the RBI resorts to increasing interest rates. During inflationary times, it is observed that the prices of commodities viz. gold and silver move up.

These three rules are the reason why diversification helps. When you have diversified your investments across asset categories, these witness non-correlated price movements. If you keep rebalancing the investments periodically, you get to buy what is low and sell what is high – though partially and without intending to do so.

An IFA’s business

In my experience, many IFA’s have their mutual fund assets under management skewed towards equity mutual funds. This leads to a very difficult situation often for the IFA. Going by the sudden flows in and out of equity mutual funds, as described above, the IFA’s AUM also fluctuates wildly. Let us go back to the market crash of 2008-09 when the equity markets saw a huge drop. Sensex closed the year 2007 at 20,286.99 points. 15 months later, it closed at 9,708.50 points on 31st March 2009. This was a drop of around 52%.

The AUM in equity mutual funds (growth funds, balanced funds and ELSS) dropped from Rs. 2.31 lakh crores to Rs. 1.18 lakh crores, a drop of 48.57%.

The drop in equity fund AUM also means the trail income dropped to the same extent. Such a drop in income is very difficult to handle. For any business, the expenses do not drop so fast and so much. The profitability of the business goes for a toss.

The above points indicate that an investor would be better off to spread investments across asset categories. At the same time, even an IFA’s business would become stable if one recommends products representing different asset categories. What products should be recommended to an investor and in what proportion are part of an investment plan – part of your recommendations based on the investor’s needs. Incidentally, such an approach helps your business, too. This is true alignment of interests.

To draw an analogy from day-to-day life, doctors and dieticians always recommend a balanced diet.

It is prudent for an IFA to have business across asset categories. It makes sense for your investor and it makes sense for stability of your business.

Don’t play in the extremes. The risk is too high – both for the investors as well as for your business. Have a balanced strategy for your business and your recommendations.

 Amit Trivedi is founder of Karmayog Knowledge Academy – a business imparting knowledge in investment markets. He is the author of "Riding The Roller Coaster - Lessons from financial market cycles we repeatedly forget"

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