Personal Finance: Hedge Your Stocks

PERSONAL FINANCE
Hedge Your Stocks

The longer the holding-period, the lower the probability of negative returns from stocks

By Dhirendra Kumar

Risk is inescapable while investing in stocks. Perhaps the greatest risk is that you will never invest in stocks because you can never be sure if it is "the right time" to invest. Uncertainty is a permanent feature of the equity landscape, and trying to discern the ideal time to invest in stocks is futile. Here are some stock truths:

SHORT-TERM RETURNS ARE ALWAYS VOLATILE. Over the last 20 years, based on the Bombay Stock Exchange Sensitivity Index's (the Sensex's) performance, the returns provided by stocks have averaged 18.42 per cent per annum. But this masks a great deal of volatility because the returns from stocks have fluctuated in a wide band. Over the past 8 years, the Sensex has provided annual returns ranging from a low of Ä24.63 per cent in 1998 to a high of 91.03 per cent in 1991. Volatility is the principal risk, and is remembered for a long time after prices fall. The best way of managing this risk is to invest for the long term.

One can draw 3 conclusions from long-term equity trends. First, time reduces the risks of holding equities. Second, there is no guarantee that you will earn the long-term average of 18 per cent every year even if you hold stocks for 2 decades or more, as this is a historical return. Third, 1990 and 1991--when the Sensex provided returns of 33.82 and 91.03 per cent, respectively--may already have provided a chunk of the returns that can reasonably be expected in the next several years.

GO BY HISTORICAL RETURNS. While long-term averages do not predict short-term results, they provide clues to what investors may expect over a period of time. Be patient. By riding out the inevitable bear markets, and avoiding the temptation to sell when prices are down, you enhance your chance of achieving solid returns. History suggests that the longer the holding-period, the lower the probability of negative returns from stocks.

BEAR MARKETS ARE PART OF INVESTING. Emotion can rule the market over periods lasting several years. Successful investors acknowledge the power of emotion, and try to understand their own investing psychology. Don't be excited when the stockmarket offers big returns, and avoid panic when there is a sharp downturn in stockmarket prices. The danger during bear markets--a prolonged period of low and falling prices--is that an investor will sell at, or near, the bottom of the downturn.

TUNE OUT MARKET NOISE. Don't be swayed by market fluctuations or the cacophony of predictions from market analysts. Your investment strategy should be based on your personal objectives, time-horizon, risk-tolerance, and financial circumstances. It should not be determined by the direction of the financial markets or the opinions of "the experts." Even if you have a large sum to invest in stocks or bonds, invest in phases over a time-frame. Similarly, if you decide to sell a portion of your holdings, redeem the shares gradually. This strategy of rupee-cost averaging can reduce the risks of investing.

Investing is a long-term voyage. Develop an investment strategy and a goal, and, then, steadily pursue that goal.

Happy investing!

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