Do not chase one or two big ideas

We have had a sharp bounce from the lows of March 2009 in a compressed period of about 45 days. A bear-market rally is underway across global markets. The decisive election outcome for India has, however, probably led to a situation where even when there are corrective phases in the ongoing bear market, Indian equities may not reach the lows of March 2009.We may be having a higher floor in place in India, courtesy the verdict of the people.

The key question for investors is how to approach investing in the equity market. We examine this aspect with a quick snapshot of where we are in the worst economic crisis since the Great Depression of the 1930s to do a quick reality check.

Macro backdrop stays weak: The underlying economic conditions – even if a few indicatives point to a feeble recovery in the developed world from a low base for the next couple of quarters – do not support such compressed-period exuberance. The world is a long distance away from making a decisive and sustainable recovery. Multiple risks loom, as the developed world gets used to an order-of- magnitude decline in level of economy activity and a new lifestyle (refer Real life examples of recession on page 6 for examples of a broad trend). Such thoughts are, of course, anathema to the `green-shoots’ brigade cheering the equity-market bounce over the past three months. `Green shoots’ are two words about which investors should be most wary of,over at least the next 12 months.Do not get taken in by them and also be wary of what one hears from officialdom (remember,not one of them gave us a clue of what was in store in terms of the economic crisis), especially in the developed countries.

Slightly different setting now in India: The exuberance part is true in the Indian context, too. What has, however, altered is the perception and expectation about the economy over the next five years, courtesy the election verdict. What is the contrast is the fact that our financial system is in good shape and the government is not required to indulge in mass bailouts that is now a common factor of life in the U.S, U.K, Japan and most other developed world nations.To that extent, India can focus on genuine recovery and growth.This is the backdrop in which investors will be making decisions now.

Avoid chasing the next big idea: The bounce from the lows of March was led by large-cap stocks folowed by a more pronounced bounce in mid- and smal-cap stocks.Real estate,infrastructure and financial services have been at the forefront. Should investors seek one or two big ideas in terms of the cap curve or sectors to try and catch the next upward move in the market (whenever it takes place)? With many-an-investor having a missed-out mindset, it is quite possible to think on such lines. The temptation will also be there especially since memories of 2003-2007 are still fresh despite the mauling of 2008.There is the possibility that such an approach will only lead to higher risks in a portfolio without commensurate returns.There is no way of telling whether this approach will even deliver. Remember that moving from one big idea to another also results in costs that will definitely show up by way of a cut in returns over the long term. This gets us to an aspect that only a few investors take into consideration.

Take a look at risk, too: How one looks at such numbers of returns must also change to ensure more insight into the decision process: Investors should not be consumed just by the absolute returns.To bring risk dimension in, just divide these returns by a simple measure such as standard deviation of daily returns. Then compare the numbers for different options– absolute returns and risk-adjusted returns. Your investment preferences could suddenly appear as - not so attractive. The differential over the broad market would be significantly lower and this tells us that taking too much risk with just one or two spaces in the equity market is not worth the while. Why? In a downturn in equity prices, the parts of the market with higher standard deviation of daily returns will inevitably take a more pronounced pounding.

Important to remember & not forget 2008: To ensure that such aggressive investment approaches are given the short shrift at the initial stage itself, it would help if the mauling of 2008 rather than the exuberance of 2003-2007 is at the top of the pecking order in investors’ mind space rather than the exuberance of 2003-2007. Just pin- up or save a soft copy of a sheet of how different parts of the market – cap curve and sectors – fared in 2008.This will temper our approach.

Good, old-fashioned approach is appropriate: This is what should drive an investment decision. This means a sizeable allocation to fixed-income. For the equity part of the portfolio, irrespective of a person’s background, large-cap stocks/pure large-cap funds should be the core. Depending on individual preferences, the allocation to this space could be between 60%- 85%. Investors with higher risk appetites could consider adding a mid-cap dimension through dedicated funds with a track record to the extent of about 15%-25% of a portfolio. An allocation of 15% to themes that are likely to drive growth in India over the next five-to-ten years could be considered by investors who wish to take higher risks.A part of this component could also be used to take an exposure to emerging markets. This indicative pattern could provide the broad contours of allocation at any stage and it is not any different now.

(Published in The Wise Investor (March 2008), a monthly publication of Sundaram BNP Paribas Asset Management.  The views expressed are personal and do not necessarily that of the organisation.)