A lot of investors in the last 8 years have not really seen a violent correction in the markets. Ok, there have been sharp corrections in 2011 and then again in 2013, but in terms of magnitude and ferocity they were nowhere close to what we have seen in 2000 or in 2008. How did we arrive at this judgement? A classic signal is how the NAVs of equity mutual funds behave in the aftermath of the correction. Remember, mutual funds are supposed to be diversified instruments and therefore they should be less vulnerable. Back in 2000 and 2008 we have seen NAVs of equity funds launched at the peak losing anywhere between 60-80%. That is what carnage is all about!
The bigger question, however, is how should investors react to such a situation. It is very easy for us to ask investors to be patient, but that is easier said than done. When the market corrects sharply and mutual fund NAVs start to plummet, the need of the hour is a systematic approach. Here are 6 key rules to drive your equity MF strategy when the market sees real damage..
Do a portfolio review and look to reallocate assets
This is the first step you should undertake when you are clear that the market is likely to see deep losses. To begin with you need to review your overall asset allocation. Does it make sense to continue your current exposure to equities or should you temporarily park your money in a debt mutual fund or ever a liquid mutual fund. Shifting money may have a cost but you would be smarter than just watching your NAV depreciate. Within your equity corpus, you need to take another important decision. Should you stick to active or passive allocation? Stock selection is never an easy task when markets are volatile. If you are betting on the markets to eventually bounce from lower levels, you are better off buying an index fund or an index ETF. You can participate in the market bounce without taking specific risk and at a much lower transaction cost.
It is the time to buy into strength and sell into weakness
This is a key decision when you see the markets correcting sharply. Identify which are the themes that are falling sharply due to froth. For example, in 2000 it was technology & telecom while in 2008 it was real estate & infrastructure. These sectors created the froth and they also worsened the correction. If you have MFs loaded with these stocks, it is time to do a switch. You have to sell into weakness and buy into MF themes and sectors where you can actually see strength.
Consider the tax shields on booking losses as a source of income
This is a slightly more complicated argument but it is popularly used by many large investors. Assume that you are holding on to an equity fund and it is down in the last 10 months. In case you are already having short term gains during the year, you can book a loss on this equity fund and repurchase it after a few days. That way you hardly lose anything in terms of market value but the notional loss is converted into an actual loss and is used to reduce your overall tax liability. Remember, even if you don’t have profits to write against, you can still book these losses and carry forward for a period of 8 years. This is quite a tax-efficient strategy.
You don't know the bottom and you never will
When the markets are cracking, never try to outguess or predict the market. The truth is that you do not know at what level the market will bottom out and you never will know. What you actually know is the mix of your portfolio and your risk exposure. Your focus in these times should be more on managing the risk. In fact, if you are doing a SIP on a mutual fund, you can use your judgement and increase the size of your SIP when markets are sharply down so that your average cost of the SIP comes down.
Get your shopping baskets out
This, in a way, is an extension of the earlier point. You were willing to buy equity funds when the Nifty was at 25 P/E. Then why are you shying away from buying equity funds when the Nifty is at 16 P/E. Treat equity mutual funds like a normal bargain shopping and try to get the best price. A sharp correction is a golden opportunity since you are going to get quality funds with great portfolios at attractive prices. There are those mid-cap and large-cap funds that you always wanted to buy. Here is the time to buy quality at cheap prices. This is the time to selectively get your shopping baskets out.
Let your head rule over your heart
This may sound a tad philosophical, but it is important to your decision making process nevertheless. You must let your logical judgement and reasoning rule over your emotions. Your emotions may drive you to average the fund that has corrected over 50% in 3 months. Please consult your logical judgement first. Even it comes to digging for values at lower levels do not get carried away by the emotion of fear that is prevalent in the market. If your head dictates that it is a value buy, as well go ahead and buy it.
Remember, a market correction is a great opportunity for serious investors. In fact, if you prepare yourself with a quality portfolio in the midst of this carnage, you may be well positioned to capitalize when the next Bull Run strikes!