The art of investing in falling markets

Question for you. Who has more chances of making money --- an investor who buys at an index level of 9300 when its on its way up or someone who buys at the same level when it's on its way down? The answer is obvious.

Putting it another way. On Thursday the market closed at 9296. Last time the market closed at these levels was around mid-December, 2005. I bet a whole lot more people were buying at that time than are today. Same index levels, different reactions.

There itself lies the paradox of equity investing. Regular readers of my column -- please excuse me for saying the same thing over and over again like a stuck record -- the simple rule of winning in the stock market is to Buy Low and Sell High.

Most investors may find that they have been Buying High to Sell Higher  or Buying High and Selling Low when the market reverses its trend.

Each investor -- I repeat -- each investor that I spoke to told me that he or she was in the market for the long-term -- at least for five years. However, it's only a month from May 10, 2006 when the market touched its highest and the very same investors have sold out or are at the brink. Some have even incurred huge losses.

The situation reminds me of French moralist, Joseph Joubert's words: 'When you go in search of honey you must expect to be stung by bees.' Translated into the context, it would mean that if you enter the stock market, you should be willing to withstand volatility.

Lets get a perspective.

The index has risen by 81.9%, 40.5% and 55.7% respectively over the last three years. What does this translate into? An investor who had invested three years back would have made an absolute return of over 377% on his capital. A two year old investment would have grown by 197%. Of course, a one-year old investment would grow by 81.9% (the same as the index).

These are the index figures. Even a run of the mill equity scheme has outperformed these numbers. And in spite of this, we cannot take a 22% fall? I know, since the bases are different, the 22% actually translates into over 40%. Still -- in the light of the past returns, it isn't as bad as the media makes it out to be.

The reasoning is simple. Over time, money chases earnings. In the stock market, corporate earnings alone are omnipotent. Nothing has changed in the span of a month to make our erstwhile blue chips fundamentally unsound. In other words, the index fall is not linked to corporate fundamentals.

Corporate earnings will still grow at a healthy pace of 14% to 16% -- if not at the earlier estimated 22% to 25% YoY. Which basically means that this is the minimum net return that an investor would get on his investment over a period of time. Of course, barring short-term volatility.

Also, it's a good thing that the correction, as it were, has come so fast, so soon. Further downside potential hereon is limited. Even if the market were to fall to 7500 levels (worst-case scenario), it means a fall of around 17% to 19% hereon. Remember this is on a worst case basis. Chances are it won't go that far.

However, no one has seen what tomorrow brings. Though it's a question of when and not if, no one can say when the market will recover back to its earlier levels. It may take three months or six or even more -- much more. But know that just like night follows day and day follows night, markets will rise and fall only to rise again.

Money can be made and lost depending upon how you play the ball. Not keeping the eye on the ball and instead trying to play the situation is like trying to put handcuffs on an octopus. There are simply too many factors both global and local that affect the valuations -- and timing the same is a lost cause.

Instead invest regularly -- on the way up and on the way down. More importantly on the way down. There is also another very important benefit in investing on the way down. It helps you prevent a situation of having invested at the medium term peak.

Have a look at the following table:

Rate of Return = 13.20%

The example assumes that a lump sum investment is made on the 18th of May when the market is almost at its peak. After which it falls and it takes all of 18 months to recover. The NAV at the beginning is Rs. 50 and the NAV after 18 months is Rs. 60.23 (an absolute rise of around 20% over all of 18 months). The rate of return works out to 13.20% p.a.

Now, if the same investor, instead of investing at one time, had spread his investments over the period, the following would be the result.

Rate of Return = 39%

Notice that the NAV steadily falls for the first six months of starting the investment. This will happen in a falling market. However, the investor has kept his investment amount constant.

After a fall of almost 28% (from Rs.50 to Rs. 36), the trend reverses and the market starts rising again and so does the NAV. After 18 months, it reaches Rs. 60.23 just like in the previous example. The total invested amount over the 18 month period is the same -- Rs 3,00,000. However, the rate of return has jumped to 39%!

Does your investment style belong to the first table or the second? Answer the question honestly to yourself.

Throughout history, smart investors have recognized a fall in valuations  as an opportunity to buy cheap. This fundamental principle never changes. To put it differently, it is the darkest before dawn. Its up to you to benefit from this darkness. Question is, are you up to it?

The writer is Director of A N Shanbhag NR Group, a Mumbai-based tax and investment advisory firm. He may be contacted at sandeep.shanbhag@moneycontrol.com

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