7-point action plan for Successful Investing

7-point action plan for Successful Investing
2007-10-01 15:13:17 Source : Moneycontrol.com

The financial markets turmoil caused by the sub prime issues in the US mortgages market is one more reflection of a grim reality of modern times...uncertainty is here to stay and the destabilizing impact on the markets has been increasing with time. Be it geopolitical tensions, natural disasters, asset bubbles and their consequent corrections, a host of events contribute to making the modern financial system extremely volatile. The global linkages of capital and investors mean that the correlation between geographies and asset classes has become stronger. Hence investors have to be smart and vigilant to ensure that the short-term mood swings of the markets do not unhinge their long-term financial plans and welfare.
So what is the prudent method to adopt in such times?

We have a 7-point action plan for investors:

1. Understand Yourself:

This is the starting point and is especially essential in such times. Start from the beginning - Assess your risk appetite, your time horizon and your financial goals. This will help you to understand if your current portfolio allocation is in line with your particular situation. In bull runs, the assessment of risk appetite gets inflated, while in bear markets, investors underestimate their ability to take on risks. Similarly, if you are investing for your retirement in 20 years as a financial goal, stock market gyrations over the next 3 to 5 years are irrelevant. After assessing these three parameters, look at your earning, saving and hence investment potential. Based on this you will have an idea of your ideal asset allocation...how much money to put in stocks, bank deposits, gold etc. And no better time than times of turmoil to spend a few critical moments evaluating what you have, where it's located and where the holes in your investment ship may exist.

2. Understand the Risk Reward Equation:

So called safe investment options like Bank deposits, while giving steady returns, lead to erosion of purchasing power due to inflation and taxes both. At 5 % inflation, Rs 1000 today will be worth only Rs 230 in ten-year time. Over the last 27 years, while inflation averaged 7%, 1-year bank deposits, the most popular category, gave before tax returns of 7.5 %. Similarly, what costs Rs 1000 today, at 5% inflation, will cost Rs 1629 in 10 years time.

Stock markets give superior, inflation-adjusted returns, but in the short term they give a roller coaster ride. Hence its critical to understand the nature of each asset class, the type of returns, the risks associated with it and the optimal time horizon for them. If you are asking, "Is this a good time to buy", you are on the wrong track. The question to ask is, "Will this investment / financial plan help me meet my long term goals?"

3. Understand Markets:

In the short term, stock markets are influenced by sentiments, while in the long run fundamentals are the key determinants. What is certain is that the stock market is a volatile animal, marked by euphoric highs and depressive lows. Indian markets have historically had a decline of 10% or more about once every two years. Even in the greatest bull market we have ever seen, from 2003 to 2007, there have been sharp declines. That's the nature of the market, even in good markets we have declines, and trying to predict its direction over the near term is an exercise in futility. Since 1979, we've had 18 corrections – or drops – of 10% or more. Investors who understand the fundamentals of the market don't panic or pull out when the cyclical declines take place.

4. Understand Long Term:

Over the last 28 years, the Indian stock market has yielded a compounded annualized growth of 20% per annum as reflected in the BSE Index, which has moved from 100 in 1979 to 17,000 in September 2007. Similarly, in 1992, from a market capitalization of Rs 160,000 crore, the Indian markets have moved up multi fold to a market cap of Rs 45 lakh crore in 2007. If in 1992, we knew our money would go up 28 times roughly in the next 15 years, all Indian investors would have put their entire savings in the stock market. However, we are happy in locking our money for 15 years in PPF accounts giving 8% assured returns. What is needed is an understanding that if you invest for the long term, i.e. for 10 years or more, the chance of making a loss is nearly zero, while the upside is many times that of other "safer" investment options. This understanding of what is truly long term is critical for financial health, and will lead to investors having peaceful sleep in times of high volatility.

5. Understand Diversification:

Diversification has and always will be the most critical component to investing wisely.

Keep funds equivalent to 6 months of expenses in a liquid fund or savings account. Use insurance to cover the risk of dying young, not as an investment vehicle. And diversify your investments into a wide range of equities, bonds, gold, real estate and other asset classes.

Consider gold and other precious metals. Historically, precious metals such as gold have been considered a 'safe haven' in times of economic, financial and geopolitical instability.

After you have covered yourself across the standard asset classes, all you need to do is to re-balance your portfolio on a quarterly basis and hang on tight. The bottom line is to have a well spread out, responsible plan for your investments and know what you own and why you own it.

6. Understand Time and Timing:

Remember that time in the market is important - not timing. Even diversified investment portfolios can lose ground in a bear market. At that time, it's easy to be tempted to sell all your stocks and funds, and move to cash or bank deposits to wait for better times. All you have to do then, the reasoning goes, is move back into stocks on the day the stock market begins its recovery.

The problem is, nobody knows when that day will be. And if you miss getting back in at the right time, you can lose a huge portion of the upside. If you were investing at the highest point of the Sensex every year since 1979, you would have made around 19.6% compounded annual returns till 2007. On the other hand, if you were a financial wizard and invested at the lowest point of the Sensex every year since 1979, you would have made around 20.2 % compounded annual returns till 2007.

7. Understand SIPs: Invest in Bad Times and Good

One of the best ways to invest regularly is rupee cost averaging through a systematic investment plan or SIP. This involves investing the same amount at consistent intervals, such as once a month or every quarter. With this approach, you don't have to try to guess which way the financial markets will move - and you won't be waiting around for the perfect time to buy while the market gallops away. Even though SIPs can't guarantee a profit or protect against a loss, they help you to take advantage of a down market by ensuring you end up buying more shares or mutual fund units when the price is down.

Market volatility is a fact of life, market decline are natural. By astute financial planning and asset allocation, investors can position themselves to ride out the waves towards financial security and success. This is as relevant in raging bull markets as they are in times of despondency. Following the above 7 Action Plan increases the odds of success manifold for the astute investor.

- Ajay Bagga

The author is CEO of Lotus India Asset Management Company.