5 mistakes to avoid in volatile investments
Many products that give higher returns also see higher fluctuations. Using them incorrectly affects your portfolio
Investments that provide income and also appreciate in value will usually see volatile returns. Think equity investments and you get the idea. But these investments make a compelling argument for being included in long-term growth portfolios because of the higher inflation-adjusted returns that they generate. Checks and balances therefore need to be built into a portfolio before investing in such volatile-returns investments. Here are a few practices that you should say no to because they can increase the risks in your portfolio and become detrimental to your investment plans.
Timing entry, exit
Apart from the fact that it can never be a sustainable strategy to invest when prices are low and sell when prices are high, there are other reasons why timing the market is on the top of the ‘Do Not Do’ list for investing. First, unless you are an expert at interpreting technical indicators, you will not be able to call the market’s highs and lows with too much success. “Things change at a rapid click and common investors are at a loss. Nowadays, it is an open economy. Events in the farthest corners of the world affect the other side. For example, how many people can truly understand the effect that Brexit will have?” said Ajay Bodke, chief executive officer and chief portfolio manager–PMS, Prabhudas Lilladher Pvt. Ltd.
Apart from the fact that most common investors would not have in-depth understanding of all the events, frequent entries and exits from any investment instrument lead to additional costs, which eat into your returns. Plus, during the time that you wait for signals to indicate the right time to invest, your money will be lying idle.
Similarly, trying to time your exit according to a market peak has two disadvantages. First, you may not have the money when you need it. Second, the market may decline before you are able to monetise your investment.
“When markets are down, many people make the mistake of stopping their SIPs (systematic investment plans in mutual funds). Even with ELSS (equity-linked savings schemes of mutual funds) this may not be beneficial because if, say, someone invested in 2007 and wanted to withdraw after the three-year lock-in in 2010, there would have been barely any returns,” said Kavitha Menon, a Mumbai-based financial planner.
It is important not to use borrowed funds to invest in volatile assets. Returns from such investments have to go towards servicing the loan. And while returns cab be high in best-case scenarios, if such an investment tanks the losses will be more with long-lasting impacts on your life. It is one thing to borrow for a car and another to do it for a SIP. A car’s depreciation does not bother you. The SIP’s will. “Investors should be clear that the return is higher than the cost of borrowing. The appreciation has to be more. For instance, it is common to take the EMI (equated monthly instalment) route to buy a gadget because it is convenient. But we forget that the gadget’s value will depreciate,” said Amit Kukreja, founder, WealthBeing Advisors.
Consider these two investments with borrowed money.
Say, an investor puts in Rs.100 in the market of which Rs.30 is her own and Rs.70 is borrowed, at 8% interest. If the market goes up 12%, the Rs.100 becomes Rs.112. Of this, she pays back the lender Rs.75.60 (principal+interest), which leaves her with Rs.36.40. This means, that on her own investment of Rs.30, she made an absolute return of about 21%. Now if the market were to fall by 10%, the Rs.100 will become Rs.90, and after paying back the borrower Rs.75.60, she will be left with just Rs.14.40. This means that on her own money she has made a loss of 52%.
Leveraging magnifies losses as much as it does the gains and is therefore a risky strategy to adopt for volatile instruments.
Growth assets with high long-term average returns need a long investment horizon to allow the investment theme or macro-economic trend to deliver attractive returns. “Don’t go by headlines,” said Bodke. “It is probable that what is called ‘smart money’ already knows about the events much in advance. Plus, markets are forward looking and would have priced in the event already,” he added.
Higher returns from such investments can be had by giving them time to ride out turbulent markets or economic downturns. “Some people check their portfolios every day; even 2-3 times a day. Then there are those who don’t give time to their portfolios. If they see it has done well, and only three years have passed, they want to exit,” said Prakash Praharaj, founder, MaxSecure Financial Planners.
If an investment is made after adequate evaluation of the fundamental factors and it periodically monitored, then it should be held in the portfolio for as long as the goals require.
“If the goal is, say, 10 years away and you are using equity funds for it, move your money into low-risk debt funds after about 8 years, in four instalments. This way your funds are protected for the goal. Same goes for real estate; money can be moved in tranches to safer avenues,” said Kukreja.
It is important to tune out the noise of short-term market responses to events, and focus on the long-term prospects of the investment. A high return on long-term investment does not guarantee the same level of returns over a shorter holding period. Investing funds earmarked for immediate goals in volatile investments, to earn higher returns, may not always be successful. A fall in market values during that period will depreciate the capital invested.
“When markets jump, many closed-end products and structured products are launched. In these, the risks are not explained properly and only a high return is indicated. And investors, even HNIs (high networth investors), adopt short-cuts to process the information. They are enticed by the returns and don’t see all the risk, and decide to invest. This is a risky trend because these are cash-trap structures—if the risks come into play, the returns will be poor,” said Menon.
So, invest in assets whose values fluctuate, only if you have the required bandwidth to weather the downward slides. “Many investors have no goal-based planning. They choose the product first—I want to buy this child plan; I want to buy this pension plan,” said Praharaj.
Booking quick profits
Trying to exploit an upward momentum in an investment, to make a quick profit, is a risky strategy unless you have the tools and information required to time and execute such trades. Inexperienced retail investors are likely to enter into a trade when the momentum has petered out and the prices are retracting. Sometimes such investors are unwilling to cut their losses and exit, even as the prices continue to sink further. At other times, greed may make them ignore the signals to book profits and they stay invested in the hope of higher prices.
The availability and regular updates on prices, and ease of making transactions, make it tempting to use such strategies to make a quick profit. But given the hits and misses, as well as the costs and taxes, the cumulative outcome may not be all rosy.
Chasing past performers
Chasing last year’s best performing asset class, industry, strategy, or product category can put your goals at risk. The risk is that the previous year’s best performers need not be the same this year. “Every asset type has a bull run and a bear run. It has its advantages and disadvantages. Focusing only on a particular asset will make you miss out on diversification,” said Kukreja.
Chasing performance necessitates moving funds from one investment to the next, which implies costs and taxes that affect net returns. It may result also in buying products that are not aligned to the needs of the investor. “The first mistake people make is taking too much advice from people who are not qualified. Each individual is different, with separate goals and risk appetite. Going after the wrong product will ruin your accumulation,” said Kukreja.
The portfolio has to reflect your goals and the ability to take risks. A diversified portfolio that is aligned to the goals will take care of having exposure to multiple asset classes. “Not just equity funds, bond funds also face risks. Investors have to understand their own risk appetite and the time frame and then decide whether a product suits their requirements,” said Menon.
Monitor the investment performance and consider a rebalancing only if there is consistent underperformance relative to valid benchmarks and peer groups. “Rigorously monitor your investments, say, every 3 months. But give an adviser at least three years before deciding to change her,” said Bodke.
Investments that have the potential to generate higher returns come with greater fluctuations in their returns. Keep the focus away from the volatility and instead focus on your investment plan. Having a plan that reflects your risk and returns preferences will help ride out the troughs and get you to your financial goals.
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