Stick to index and diversified equity funds through staggered investments.
When an investment is contemplated, it is normal to estimate the expected return and timeframe in order to compare with alternate investments. These estimates may be inaccurate. But even inaccurate estimates are better than no estimate.
Using this logic, one can estimate with high confidence that investments in broadly-diversified equity at current levels will fetch absolute returns of near 20 per cent. But it's not possible to set a timeframe and without timeframes, one can’t judge annualised return, and that is key.
Given economic cycles, every bear market eventually turns into a bull market. By definition, a bull market sees the peak of the previous bull market matched or exceeded. The Nifty has dropped over 1000 points from its peak values (6300-plus). If you invest at current levels (say, an average of Nifty 5400), by the next bull market peak, your assumed return of 1000 points will be worth 18-20 per cent.
But bear markets can last indeterminate periods. Indian bull markets sometimes terminate in 9 months or a year. They can also last 3-4 years. A short bear market may see sharper value erosion than a long bear market, where prices stagnate.
The 2008 bear market lasted 10 months with a 60 per cent pull-back. The 2000-2001 bear market lasted 18 months with a smaller pullback of 52 per cent, from the February 2000 high of Nifty 1800-plus to a bottom of 850 in September 2001. Tellingly, the Nifty stayed below 1000 until May 2003.
Those statistics highlight the fact that we don’t have a fix on timelines. They also bring focus to a third important factor. This is the “drawdown” - the potential maximum downside to any investment.
While we can state diversified equity bought at current Nifty levels will gain, we must also face the fact that such investments could run at substantial loss for a long time. If a long, large drawdown may occur, it obviously impacts the investment strategy. Ideally, an investor should enter as low as possible and average down. He can only do this effectively if he has a rough estimate of the likely drawdown from the first entry point.
Indian bear markets often see retractions exceeding 50 per cent from the peak of the previous bull market. There is no apparent reason why this 2011 bear market will be less extreme in its pullback. The current retraction is only 16 per cent down from November 2010 peaks. So, we can reasonably expect a big drawdown from the current levels. The Nifty could easily drop another 1000 points, or more. The risk-reward equation is not good.
However, when we come to comparisons, there are no alternative asset classes offering significantly better risk:reward equations. Gold is priced very high, ditto silver. Interest rates are going up, making long-term debt as dangerous as equity. Real estate has gone soft and it could under-perform diversified equity for a long time to come.
The most pragmatic strategy for a ‘long-only’ investor is to enter diversified equity very cautiously and be braced to average down. Let’s say you start with a SIP in an index fund. Be prepared to increase commitments to the SIP (or to open new SIPs) as the market falls.
If the market falls another 1000 Nifty points, you should be prepared to double equity commitments at 4400 levels. At that stage, the projected absolute return would be 40-50 per cent (2000 points gain) and the potential drawdown would be 500-1000 points. Regardless of the elapsed time period, the risk:reward equation would be favourable enough to make equity attractive.
To implement a staggered strategy of gradually increasing equity commitments needs sensible money management. You don’t know how much the market will actually fall. You must hold reserves in cash to average down. But you don’t want to endlessly hold cash, waiting for a bottom that isn’t hit.
If you are prepared to invest Rs X per month at 5400 Nifty and to invest 2X at 4400, develop a mechanical strategy for increasing commitment. For example, you could plan to increase the SIP by 20 per cent on every 200-point fall. You need to manage your cash in such a way as to do that as seamlessly as possible.
If you decide to try this staggered method, don’t waste time looking for great stocks. Stick to index and diversified equity funds, and work on smart money management instead. This is less intellectually demanding. It’s also likely to give you better returns.
