Sensex at 19,300… Time for a revisit to Investment 101

The Sensex touched a high of 19,400 today, the highest it has been in 33 months, the last time the Sensex was at 19,400 was on 17th Jan 2008.

The recent rally has been accompanied by large inflows by FII’s into India; and concerns that the markets may be heading towards bubble territory.  Without getting into a fundamental discussion about India’s growth story, corporate earnings growth, the available liquidity on the sidelines with investors who have “missed the bus” and are waiting to enter; it is a good time to review some investment basics.

The peaks and troughs of the market have taught us some lessons. One of these is that many investors have a tendency to procrastinate or delay, when the markets are in an up-move and equally in a down-move, but react with the buildup of media coverage, tips, and emotions of greed (everyone is making money, easy pickings) and fear (markets are tanking, the end of the world is near).

The result, not surprisingly, is that many are caught with investments made at the peak of the market and selling at the bottom of the market.

The affect of Greed or Fear

Markets are often driven by either greed or fear. Investors who react to news, tips and the overwhelming emotions that greed or fear can bring, often make wrong decisions, that can have a major impact on their portfolio and financial well being.

In bull and bear markets, media coverage, investment tips from your friendly investment guru next door or on TV, stories about friends or family who have made or lost a fortune, become the rule rather than the exception.

Emotions can run high when markets are making a high every day; as they can when the markets are falling; and they can easily get the better of most rational investors.

Exercising caution and not making emotional decisions is a difficult, but critical, requirement for successful investing.

Fundamentals of Investing

One cannot but emphasize the importance of returning to fundamentals. Whether the market is in a bull run or not, review your investment portfolio and strategy with the following in mind:

  1. Your investment Plan: review your portfolio with both your short term and long term goals in mind. It is important to understand what needs you may have, and what your short, medium and long term financial goals are. Remember that successful investing means taking appropriate risks based on your investment horizon and risk profile.

Remember that your short term needs will require Cash and therefore liquidity and certainty in your portfolio. Ideally, one should not take too many risks with this part of the portfolio. Any cash that you may need over the next 12-24 months should be in interest bearing securities rather than stocks. Even if the market looks like a bull run will continue, one must balance the risk – reward and protect your financial well being in case of short-medium term volatility.

  1. Fundamentals: Don’t forget fundamentals. Do your research and evaluate whether any of the stocks or other investments you have are under or overvalued. Compare your stocks performance and valuation with others in the same industry, as well as historical peaks and troughs.

Don’t take more risk than your portfolio can sustain, or beyond your comfort level. The higher the risk in your portfolio compared to comfort level (or risk tolerance), the greater the chances of an emotional decision when markets are volatile.

  1. Diversification: the golden rule of investing. By diversification, we mean:
  • Asset class – build a part of your portfolio in different asset classes. Remember, in addition to income yield / returns, different asset classes also have a different risk profile, and are differently correlated i.e. they don’t all rise or fall at the same time. This offers your portfolio some level of stability in volatile markets.

Divide your portfolio between Interest Bearing Bonds & Deposits; Equities; Gold and Real Estate. How much in which asset class should be a function of your risk profile and your short to long term plan. Keep your liquidity / cash requirements in mind and build that into your plan.

  • Securities – as the saying goes, don’t keep all your eggs in one basket. Don’t put too much of your investment in any one or two stocks. Diversify your holdings between stocks as well as industries. Remember, choose your stocks well after doing your research and invest if you believe in the company, its cash flow projections and the management. Avoid “hot” tips which are based only on rumours and where you do not have any belief. Greed could result in you holding a “dud”.

If you do not have the knowledge or comfort level to invest directly in stocks – don’t. There are many choices available in Mutual Fund schemes – both through Diversified Mutual Funds and Sectoral Funds that you can invest in. Again, do your research in the Fund House, the Fund Manager and the Scheme Portfolio and Track record.

  1. Invest Regularly: Investing regularly is the magic potion that your portfolio needs. The fact is that lump sum investment exposes one to market volatility – so while you can make large profits if you enter at the bottom of the market, a large lump sum investment can be very painful if you enter at the peak.  It is extremely difficult to time the market, and no one gets the timing right every time.

Investing regularly allows one to be invested and at the same time to take advantage of market volatility and therefore “average out” your cost of acquisition.

Stick to your plan; diversifying and building your portfolio over time. Investing regularly will help you achieve your plan faster and provide some protection in volatile times through Rupee Price averaging.

  1. Benefits of Compounding: Starting early and making your investments work longer is in many ways better than making it work harder or timing the market. Make your income work for you, whether from interest, capital gains and dividends, by reinvesting whatever you do not need to sustain yourself. In the long term, this reinvestment can make a significant and large impact on your portfolio. See Benefits of Compounding.

© 2010