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4 ways to ace falling markets
Personalfn.com | April 14, 2008 09:10 IST
Investing in rising equity markets is always easier than investing in falling markets. Since a rising tide lifts all boats, rising equity markets can make even mediocre investments appear like great investments. But when markets collapse like they did earlier this year, many of these 'great' investments suddenly start appearing like great mistakes. Nonetheless, there are lessons to be learnt from falling markets and we have a 4-step strategy on how you can ace falling markets.
In rising markets investors are usually exuberant and expect markets to continue in the same vein. This is when most investors make mistakes. Two of the more common investment mistakes are 1) investing mainly in equities (i.e. lack of diversification) and 2) add to existing equity investments which results in lop-sided asset allocation (i.e. perilously high allocation to equities).
A lot of investors fail to realise that markets do not tread in one direction for ever. Stock markets are characterised by ups and downs, which is commonly referred to as market cycles. And often, markets can take a sharp U turn. Although, the warning signs are there, investors usually choose to ignore them or don't read them well enough. And when markets turn, the higher equity allocation can appear like the most burdensome thing in the world to the investor.
At Personalfn, we have maintained that investors must aim at building a well-diversified portfolio which can prove resilient enough over various markets cycles. Here is a simple 4-step investment strategy to protect your finances in falling markets.
Diversify your investments
The two biggest advantages of diversification are 1) it reduces the overall risk of the portfolio and 2) it improves its performance over longer time frames. In an adverse scenario, diversification ensures that only a part of the portfolio is impacted leaving the rest relatively unaffected.
To understand this better consider the mad rush for gold ever since US markets were hit by the sub-prime crisis. If investors had pursued a well-defined asset allocation plan they would have invested in gold before the market fall.
This would have helped them in two ways a) they would have benefited from rising gold prices and b) since equity allocations were capped at pre-defined levels, losses would have been lower.
In rising markets, there is a fair chance that you would have invested at a higher NAV (net asset value). Now in falling markets you have the opportunity to make additional investments at lower NAV to lower the average cost of your investment.
Identify the flaws
Start your tax-planning
If you wait for the financial year-end to begin investing, you may not necessarily get the opportunity to invest at lower levels, especially if markets are in recovery mode.
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