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Home / Opinion / Columns /  There is no magical strategy that lets you participate only in the upside

What will happen to equity markets going forward? While no doubt this is an important question at the current juncture, didn’t you have the same question three months ago, six months ago, one year ago and five years ago? If you really think about it, this is a question that will perennially be a part of your life as long as you invest in equity markets.

Let us take a step back and ask something more basic—Why do you ask this question? Simple. If you can figure out when the markets are going to decline, you can step out of a crash and get back at lower levels to make a killing. Life set!

While this logic seems perfect, let us drill down deeper into some of the assumptions behind this.

Assumption 1: Someone out there knows!

Google and find out if there are investors who have managed to do this consistently over long periods. If you are not able to find anyone, no worries, you have already got the message.

Let us hear what the legendary investor Jack Bogle had to say about this: “The idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently."

While there are several investors who have got it right once or twice and go on to write books and are featured in talk shows, they eventually get the next one wrong. The reality is that there are several variables, known and unknown, that can influence the stock markets in the short run, and therein lies the difficulty of an accurate prediction. The humble truth is that no one really knows where the markets are headed in the short run. Period.

Assumption 2: I can avoid pain and only take the gain—if only I got hold of the magic strategy

Unfortunately, there is no magical strategy that lets you participate only in the upside and avoid the downside. Returns are never free. You need to pay a price just like you do for any other product. The price comes in the form of temporary declines. Going by history, a 10-20% temporary decline is to be expected almost every year and a 30-60% temporary decline is to be expected every 7-10 years.

Assumption 3: Returns can be made only by avoiding the declines

While this assumption sounds intuitive, stock markets have returned respectable returns in the long term despite enduring the inevitable temporary declines along the way. The reason is simple. In the long run, stock market returns reflect underlying earnings growth. While the change in valuations (a reflection of the moods of millions of investors) keeps the markets volatile in the short run, the impact of valuation changes diminishes over the long run (as long as you are not entering at insanely high valuations).

So, if you believe that entrepreneurs will continue to grow their profits in the coming decades as they did in the past, the equity markets will continue to provide decent long-term returns in line with earnings growth. The inevitable temporary declines along the way will be a feature rather than a bug.

Now, once you start accepting that temporary market declines are the price to be paid for long-term returns and ‘time’ is your superpower, you suddenly realize that you can invest successfully despite not having an answer to what will happen to markets in the short term.

This leads to two important shifts in your investment approach. 1. You build portfolios with the humble acceptance that you won’t be able to predict the next market crash but rather the portfolios will have to endure and survive the crash. 2. Your mindset shifts from “trying to predict market declines" to “preparing, accepting and enduring" declines.

How do you implement this?

* Choose an asset allocation mix (mix of equity, fixed income and gold) that allows you to endure the declines and stick to the plan without the need to predict and step out of a crash

* Rebalance annually if the allocation deviates by more than 5%

* Diversify across investment styles, geographies, market capitalization in the equity portion

* Build an “equity market sale!" plan

* Demarcate a portion of your debt allocation as ‘market sale bucket’ to be deployed into equities if the market corrects by more than 20%

* Preload the decisions on how you will deploy the money from the ‘market sale bucket’ into equities at different levels of declines—20%, 30%, 40% and 50% declines

* Sin a little. Build a valuation-driven framework to ‘partially’ reduce equity exposure when the markets become insanely expensive. While the temptation to overdo this will be very high as this provides for intellectual boasting rights, use such frameworks only when valuations, earnings growth and sentiments are at extremes

* Trust the best fund manager—time!

Arun Kumar is head of research, FundsIndia.

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