Crossing Hurdles

Equity investing is rewarding in the long term. However, the short-term volatility can create obstacles to wealth-building
Swapnil Pawar        Print Edition: August 2013

Karvy Capital Chief Investment Officer Swapnil Pawar
Equity investing is rewarding in the long term. However, the short-term volatility can create obstacles to wealth-building. We list some of these obstacles and how you can overcome them.

Investors tend to respond to volatility by changing their investment horizon, even though they know about the long-term nature of equity investing. A long-term multi-year investment becomes a tactical holding. Investors start to look for a good time to exit and another to re-enter at 'attractive' levels. This approach rarely works. What generally happens is a series of 'misses' where losses are booked and profits are missed.

There are two ways to overcome this obstacle. One, investors can choose instruments which do not allow them to exit at the first hint of volatility. These could be tax-saving-linked ELSS, NPS or Ulips. The second is to adopt a systematic and pre-determined investment plan with several entry points of investments, leading to some being in profit and others in loss - thus not leading to any obvious reaction from a behavioural point of view.

Volatility may throw up several opportunities. One is that several good stocks, especially mid-cap ones, are available at attractive prices. The large price swings mean that investors can actually book profits and reenter at lower levels again should the stocks fall in value.

This might seem like a contradiction to the above-mentioned first obstacle. However, in reality, this approach is counter-productive at a market-wide level while being potentially useful for specific stocks. That is because stocks have a more definable fair value. Secondly, midcap stocks in particular are far more volatile than the broader market - thus offering specific opportunities to exit and enter. However, what is crucial is making a clear assessment of what is the fair value or target price for a stock and then the discipline to exit above this and re-enter at 10-15% lower than the fair value.

A workable approach is to spot a few high quality mid-cap stocks with good management, profitable operations, low leverage and high growth. After this, one should decide the fair value of these stocks. The idea is to implement profit-booking and re-enter with a disciplined process. It is possible that many of these may not provide such opportunities since they do not fall sufficiently in value or move very far from the fair value. It is also possible that one misses a few stocks on their way up. However, in most cases this approach leads to good returns even in range-bound markets.

Asymmetric treatment of gains and losses is often a problem area for investors. Investors looking at their portfolios during volatile times tend to quickly book profits and wait for the loss-making stocks to return to the investment levels. This behaviour leads to losses accumulating and profits getting capped.

The best way to overcome this is through the use of pre-defined profit-booking and loss-booking levels. Of course, one could simply use a passive investment style and avoid the obstacle altogether. However, insofar as investors are seeing their stocks individually, they are prone to this obstacle. In such a case, keeping well-defined levels for each stock at which to book losses and profits makes sure that one is not ambivalent after the levels are hit.

(The writer is chief investment officer, Karvy Capital)

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