Fenil's Library

If you are a true blue retail investor, the kind who invests when the stock market is at its peak, and sells out when the market is at a low, chances are you would have missed the current rally.

Since March 9, 2009, when the current rally started, the Bombay Stock Exchange (BSE) Sensex has gone up by a whopping 75%. And most retail investors have missed this rally. 

Even those who have stayed invested in mutual funds have lost out to some extent because a large number of equity mutual funds haven’t invested and are sitting on a large amount of cash. 

Given this, how can a retail investor ensure that he does not miss out on future stock market rallies without taking on too much risk? 

The answer, as always, lies in “asset allocation” —- one needs to maintain wealth across asset classes such as equity, bank fixed deposits, cash and gold. 

What proportion of your wealth should be in stocks? 

This is a proverbial question. Tie-wearing experts will tell you that in the long run, stocks are the best way of investing. But how long is the long run? Is it three years, five years or ten? 

Anyone who invested in the stock market in April 1992, when Harshad Mehta’s euphoria was at its peak, would have not have recovered his money until July 1999, when investors had been taken over by the dotcom mania. The dotcom mania peaked around February 2000. Anyone who invested in the stock market around then would have had to wait till January 2004 to see his investment get into positive territory. 

Given this, investment in stocks should always be to the proportion of your income on which you don’t mind losing money at a given point of time. If you are comfortable with facing losses on 50% of your wealth, that is the proportion you can allocate to stocks. 

The easiest way to invest money in stocks is to invest it in a good index fund. An index fund is a mutual fund which collects money from investors and invests in stocks that make up a stock market index in the same proportion as their proportion in the index. In India, index funds are available on the two major stock market indices —- the Sensex and the Nifty. Since these funds track the broader index, the investor is immune to the active decisions of a fund manager. 

Balancing is of utmost importance 

Let us say you decide to have an allocation of 50% to equity and 50% to other assets. It is important that this asset allocation is maintained. So when stock markets fall, you buy stocks to maintain the allocation and when stock markets go up you sell stocks to maintain the allocation. This strategy will help you follow the quintessential market wisdom of buying low and selling high. Retail investors typically end up doing the opposite: buy high and sell low. 

It is very easy for investors to believe during a bull run that they will continue to invest even when the stock market falls. It is only when there is a bear market is upon them that they realise how psychologically difficult it is to invest when a bear market is on, and when they can see the value of their investment continuing to fall. The balancing strategy ensures that investors can continue investing small amounts in a bear run, ensuring that once the market rebounds, the chances of making money are much better. 

Investor greed is coming back 

If you are the kind who follows the stock market closely, you would have realised that optimism is coming back to the market. A leading international financial institution now feels that the Bombay Stock Exchange Sensex may touch 19500 this year. Mutual funds which had not been launching new equity schemes have started launching new schemes again. At an individual level as well, investors are feeling more confident and some of them have even started sharing hot stock tips, once again. 

The bigger question though is, if investors were not ready to buy when the Sensex was at a level of 8000, why are they ready to buy at a level that is nearly 75% higher? The law of demand tells us that higher prices dampen demand and lower prices increase demand. This seems to work everywhere except in the stock market. As the stock prices go up, the more stocks appeal to investors. And that explains why investors are coming back to the market. 

The herd mentality 

“A fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a zeitgeist, a spirit of times,” writes economist Robert Shiller in his book Irrational Exuberance.

A retail investor looking to invest largely looks at the situation around him. What he checks out is whether the people he knows, his neighbours, relatives etc are investing. If they are investing, he too invests; if they are not, he doesn’t. Confirming to the herd is the safer thing to do, even though it may not be the right thing to do.

As John Maynard Keynes famously wrote “Worldly wisdom teaches us that it’s better for reputation to fail conventionally than succeed unconventionally.” 

Also, in uncertain situations, like the stock market, people tend to look at the familiar past pattern and assume that the future patterns will be identical to the past ones. Since investors do not know exactly what will happen tomorrow, it is easier for them to assume that the future will be similar to the recent past than to admit that it might bring in some unknown elements. So when the BSE Sensex was at a level of 8000, investors assumed it will continue to fall. And now, when it is at a level of 14000, the investors see that the going has been good in the recent past, and they feel this will continue in the days to come. 

That’s why, if you are a true blue retail investor, you are more likely to have invested in the stock market in the recent past, rather than when the market was around 8000 levels.