Why timing the markets can be risky for investors

If you have ever travelled on a Mumbai local train, you would know the difference between boarding at 7.45 am and 8 am on a weekday. While timing may be important to board your train to work, using the same strategy may cost you dear when investing in the markets. Timing the market or bottom fishing can be a risky proposition, especially in the short term.

Every now and then, the market reacts to biases which can throw up opportunities for investors. Nimesh Chandan, head, investment (equity), Canara Robeco Mutual Fund, in a recent presentation at a Café Mutual conference, argued that the markets tend to overreact to news. He used behavioural economics to make his point, referring to studies which showed that participants agreed with an incorrect answer to a factual question if a large group gave the incorrect answer. This outcome was also observed if people perceived to be having a “high status” (think today’s influencers) gave the wrong answer. Spotting these biases does provide attractive opportunities to investors, he argued.

As markets correct due to the spread of Covid-19, also known as novel coronavirus, a large number of people are exiting out of fear and panic, leading to an over-correction. In the current situation, you might be left wondering whether this is one such opportunity.

The benchmark Nifty 50 index (as on 12 March) was down more than 20% from its all-time high, and it may also seem like an opportunity for bottom fishing. Before you rush to invest, it’s important to not lose sight of your asset allocation and goals because if you have a short term view you may end up with a raw deal. It’s important, therefore, to know the minimum and maximum one-year returns after this sort of correction.

A study by Kuvera, an online mutual funds investment platform, on the historical returns from Nifty 50 between 1990 and 2019 reveals some intriguing statistics about what bottom fishing can lead to.

Investing in the market after a correction in the range of 15-20%, has historically given a positive compounded annual growth rate (CAGR) of 13.4% over the next one year of investing (see graph). But the minimum and maximum CAGR figures show a wide variation. In the range of 15-20% correction, the one-year minimum return was -50% and the maximum 154%, among all the one-year periods between 1990 and 2019. In other words, by following this strategy, you could have lost half your money over the next one year, but on the positive side, you could have more than doubled your money. In terms of probability of beating the risk free rate over the next 1 year, this stands at a healthy 72%.

What if you extend your time horizon to three years? In such a scenario, the average CAGR actually falls to 12.4%. However the minimum CAGR rises to -14% from -50% over a year and the maximum falls to 50% from 154% a year. In other words, your average return increases and the range of historical return falls. The tendency to narrow the range of maximum gain and maximum loss, grows stronger if you wait for five years after the correction. This is because excessive pessimism and exuberance in the market gets ironed out over time. Your probability of beating the risk free rate over the next 3 years also improves to 85%.

Another scenario that Kuvera examined was a deeper correction of 20-25%. In this scenario, your average return after one year improved from 13.4% (for a 15-20% correction) to 15.7% (for a 20-25% one). However, your worst and best returns didn’t change that much. The worst return was -44% and the best return was at 206%. Your probability of beating the risk free rate actually decreased from 72% to 64%, probably because a correction of this magnitude was more long lasting than a shallower 15-20% drop. Here, once again, waiting for longer periods of three and five years reduced the range of positive and negative outcomes.

“What the data is telling us is that when you are in a market correction, the near future returns—one to three months—can be very volatile. But if you are prepared to hold for five years or more, the odds are on your side to get good returns,” said Gaurav Rastogi, chief executive officer, Kuvera.

“Of course, the worse the market correction, the better the future returns look, but that does not mean you should wait for them. Predicting corrections is very hard and your money will stay idle, or worse, miss a long-term rally just waiting for markets to correct significantly. The better strategy is to rebalance more of your portfolio into equity as a correction deepens to take advantage of the higher future returns,” he added.

Some mutual funds, such as hybrid funds, automate this strategy. The fund manager will shift into equities from bonds, as the former get cheaper and cheaper.

What you should do

Bottom fishing or timing the market is not a strategy that ordinary investors should follow. The adage, “time in the markets is more important than timing the market” generally holds true. The recovery in stock markets can be sharp and sudden and by staying on the sidelines, you can end up losing out on a the bulk of market returns. The stomach-churning volatility and the fear that market timing generates is also not easy to digest.

Kalpesh Ashar, founder, Full Circle Financial Planners and Advisors, cautioned investors against losing their emotional balance and giving in to panic. “First of all, I would ask people to control their emotions. Those who have financial goals and have SIPs (systematic investment plans) or STPs (systematic transfer plans) in place to invest for them should continue with that. If someone has additional money to invest, he should look at investing a lump sum as well as starting SIPs or STPs in the chosen funds, in order to spread out his investments,” he said. An SIP invests a fixed amount in a mutual fund at regular intervals, while an STP moves a fixed amount every month from a debt or liquid fund to an equity fund. Both achieve the objective of spreading out your investment evenly and protecting you from investing all the money at market peak.

Ashar also urged investors to be choosy about the funds they select. “The funds for the type of investment I have suggested should be preferably in large- and multi-cap schemes that are of high quality,” he said. In other words, don’t look for schemes which have fallen the most. Pick high-quality ones that are likely to rise substantially during a recovery.

If you are determined to catch the bottom, keep the historical statistics in mind. You can also mitigate your risks by extending your time horizon so that the market gets enough time to recover and move to the next cycle.

The markets are witnessing the much-needed correction and while this presents good investment opportunities make sure you keep your asset allocation in sight.