There is always the urge to do something. And one that has been exceedingly common in recent times is: Exit the market, wait on the sidelines, and enter when it crashes.
Fundamentally sound, but execution won’t be pretty. To start with, market irrationality can last a very long time. Further, trying to pick a single-entry point requires you to be psychologically astute.
Let’s say you are waiting on the sidelines. The market drops by 10%. You wait. It drops by another 10%. You wait because you are convinced it will fall further. It declines another 10% and now you are convinced bad days are coming, so you want the market to bottom out. Suddenly, it begins to rally and you missed timing the bottom. You would have lost out investing at lows and not caught the rally either.
That is why timing is not a good strategy. Here's how to combat these inclinations.
Strategy 1: Differentiate between stock performance and business performance.
Shift your focus from the movements of the stock price to the performance of the underlying business.
If it qualifies on these three fronts, it will increase per share value for its stockholders over the long term. You may be pleasantly surprised to note that the potential growth in value is sometimes mispriced by the market even if the stock has already appreciated significantly.
Instead of making a decision based on paper profit, seek to answer these questions: Is this business growing and making more money per share than it did a few years ago? What is the potential value of the business 10 years down the road?
Professor and investor Sanjay Bakshi, suggests three factors in the analysis:
- Businesses that can deliver growth without stretching balance sheets.
- Businesses that can deliver growth without taking in more capital through the issuance of new equity shares.
- Businesses where the quality of growth is excellent in terms of incremental returns on capital.
Getting a grip on the above will help you make decisions based on the business performance, and not get swayed by the stock performance. It will also throw clarity on the distinction between external stock market forces driving a stock price as against business reasons.
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Strategy 2: When your eyes are on the horizon, the bumps on the road are easier to stomach.
A precipitous market drop induces panic. And that is the time investors need to fight off the urge to sell their shares and crystallise losses.
A dizzying market rise causes investors to throw caution to the wind, and tricks them into believing that they are stock market geniuses.
Fear sells. Excitement buys.
Morningstar’s director of behavioural finance, Sarah Newcomb, says that instead of attempting to ignore your emotions, channelize it. In a down market, put your nervous energy into searching for assets that are selling at a discount relative to their fair market value. Understanding the difference between fundamental value estimates and market prices is essential to finding those quality companies that might be temporarily undervalued because of general market skittishness. Turn that agitation into excitement about the buying opportunities that only down markets can bring.
In a rampant bull market, keep a focus on your asset allocation, and goals.
In Enough: True Measures of Money, Business, and Life, John Bogle makes some pertinent observations. “Rampant greed threatens to overwhelm. Not knowing what enough is subverts our values. This confusion about enough leads us astray in our larger lives. The worship of wealth results in the growing corruption of our ethics, the subversion of our character and values.”
When you have made more from the investment than you anticipated, it takes courage to head for the exit. Because there is always the lure of more - “If I wait for a few more days, I can make more”. You need to ask yourself, will selling take me closer to my goal. Your goal is not to make profits – that is the goal of a trader. Your goal is wealth creation.
Check your personal stress level, and asset allocation.
If a stock has risen to a point where it becomes to big part of portfolio and gives you sleepless nights, sell it down to the “sleeping point”. It's not just about making money, it is also about a living stress-free life. What’s the point of becoming so rich that you’re not unable to even sleep?
Pare down exposure in a bubble market, if you want to reduce your anxiety. In other words, asset allocation.
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Strategy 3: A long-term mindset is not necessarily a fixed number of years. It is when you know what is enough.
There is a popular story about a conversation between Kurt Vonnegut and his pal, author Joseph Heller. They were at a party on Shelter Island, hosted by a hedge fund manager. Kurt joked that the host may have made more money in a single day than Heller had earned from his wildly popular novel Catch 22 over its whole history. Heller responds, “Yes, but I have something he can never have. The knowledge that I’ve got Enough.”
A lot of people incorrectly assume that they need enough money to do nothing. You just need enough to do whatever you want. The power is having a choice. The choice might be to work less to spend more time with family, to go back to university, to start your own business, to travel, or perhaps even take a job that pays you less but gives you purpose when you wake up in the morning.
As investment guru Bill Bernstein once advised "if you've won the game stop playing." You need to identify your own version of "winning" and "enough".
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Strategy 4: Focus your energies on things you can control and tune out what you can't.
Should you get ruffled during volatile times, Morningstar’s director of personal finance, Christine Benz, suggests that you:
- Revisit your savings rates
- Review your long-term asset allocation
- Streamline and improve your investment choices
- Assess the adequacy of your safety net
- Make reasonable investments in your human capital
You hold no sway over the direction of the economy or the market; they're going to do what they're going to do. But you do exert at least a modicum of influence over your own situation: how much you save versus spend, how you've allocated your portfolio, whether you've built an adequate cash cushion, and so on.
Don't try to time the market by switching to cash. Unless you are extremely lucky, you won't get rich playing the timing game. The old "buy and hold" mantra may seem like cold comfort at times like this, rest assured that it has a better long-term record than market-timing.
Markets are marked by false bottoms (and ceilings)--points at which it appears that stocks won't fall (or rise) much further but then proceed to fall (or rise) even more. Anyone who tries to trick the bear (or the bull) by piling up cash will likely suffer less-than-perfect timing and miss out on big stock-market gains.
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Larissa Fernand is Senior Editor at Morningstar India. You can follow her on Twitter.