In a crisis, shun risky bets

When stock markets tumble, it is tempting to go back and replug the warning signals. Or re play the risks previously highlighted. Or find faults that confirm the current beliefs about everything that is wrong with China. Or explain how India is different. No one can predict the exact point of meltdown, or tell us when things will be better. No amount of data or analysis can provide precise predictions.Which is why it is foolish to think of a suitable strategy in a crisis. Sometimes pulling back and doing nothing might be a good thing.
The simplest way the human brain deals with complexity is by forming thumb rules. We look for patterns and predictability, and make decisions using past experiences. The real world is more complex. Thinking about 2015 as a replay of 2008 or linking the two mentally might not help. Every crisis unfolds uniquely, and the pieces fall together for an economic historian who picks up commonalities a few years later. To a simple investor, it is important to step back and let events happen, without overt eagerness to decipher them instantly.
Markets feature cycles of action and consequence or boom and bust. Active government intervention disturbs this natural process in a manner that makes it tough to see whether the corrections and consequences have played out at all. It is unknown whether the unintended consequences of policy interference are helpful or not. In a crisis, liquidity is hit first and reducing interest rates is a default action. Most governments take this step anyway. It is not known whether buying to stop a fall in prices, banning selling, spending government money until the economy recovers, keeping rates too low too long, managing the currency actively and controlling capital flows are helpful. We also do not know whether there is anything like "good" or "bad" government action.
Believing that everyone--government, institutions and investors--must act in a crisis, and basing that action on past experience, can result in new risks. Or the quixotic situation where generalisations are made to oversimplify risks. Some popular truisms are: Invest in a crisis to make the most. Long-term investors should not worry about such events. Money is made when you invest in a falling market. Buy when things are cheap. Down cycles are for buying into commodities. A crisis is not the time to buy risky assets. Period. Protecting what one has should precede staking even more.
Traders and speculators wind down positions when a crisis hits. They cannot take capital losses, especially since they have leveraged their positions using borrowed money. They also move money across positions, selling in one market to pay in another, which is why Indian markets crash when global markets fall. Fund managers and portfolio managers are judged for their performance on an ongoing basis and their clients act with their feet. Thus they take defensive action to protect downside losses. Institutions tend to get conservative with their asset allocation, moving into cash and less risky assets. It is tough to understand how and why our simple investor is advised from all quarters that he should keep up his commitments to buy and remain invested through a crisis. Or invest more when the best in the business are selling.
The common argument is about timing the markets. Many market commentators argue that investors should take advantage of every crisis. Some others say investors will not be able to return at the right time, so the best thing is to stay invested. The problem is that as the crisis deepens, investors will get uncomfortable but find it difficult to take action. If they do not cut back risky positions when the crisis begins, they are likely to hold on and hope that things will be fine. After experiencing the pain of steep corrections, they tend to quit right at the bottom of the market. Simply because patience has worn thin. Therefore, they make the twin mistake of coming at the top and quitting at the bottom. Leaving early when the markets are in a crisis provides the cash to come back when markets have fallen. Fresh money should go into conservative assets like cash and debt. Risky positions in equity , commodity and property should be pulled back to the minimum and no fresh allocations done.
There are two difficulties for the simple investor. The first is lack of asset allocation strategy. An investor with longterm goals may have 50%-75% in equity, while a conservative investor may have 10-30% in equity. To think that everyone should sell off all risky assets they have is wrong. Crises like these are times to return to the minimum threshold of exposure to risky assets. The second difficulty is inability to sell at a loss. Investors like to hear advice that asks them to sit through a crisis, because they are reluctant to act when they have to book a loss. A meltdown points out the mistakes of the earlier enthusiastic buying spree.
What would you do if you encountered a treacherous stretch of road when you were driving with the sun and songs?
You would slow down, look carefully as you changed gears, or think about alternatives. You will still resume your journey, but you won't make new plans or speed up. It is the same with investing. It is your money. Protect it.
(The author is Chairperson, Centre for Investment Education and Learning)