Amidst the market mayhem we have witnessed in the past fortnight, market pundits have voiced a variety of opinions, including the likelihood of persistent volatility, the relative safe haven India offers among emerging markets, and the need to stay invested. There sure is a grain of truth in many of these opinions – but that is not the point of my blog here. What I would like to focus on are the few silver linings that this market upheaval has brought to us.
The fragility of prices
What comes to mind first amidst all the slaughter that has ensued is the fragility of stock prices. This has been a golden opportunity to remind us that stock prices are values that rest on the knife-edge of confidence. When confidence is high, stock prices float to stratospheric levels and are as likely to be savagely brought down when confidence is low. As investors, this reminds us that 'confidence' is a fickle thing and is subject to mob mentality. We must internalize this aspect of the market and use it to our advantage.
The fallacy of 'its all in the price'
Modern economic theory purports that in a perfect market, everything an asset is worth is embedded within its price and that perfect information coupled with market forces of supply and demand ensure prices are in 'equilibrium'. Events of the past fortnight and the many extreme events that have unfolded over human history bring into sharp focus that either the market is not perfect or information is not perfect or this so-called market equilibrium is so vulnerable that there is no real meaning attached to it.
Prudence over greed
The prudence of diversification, cash, and real assets is underestimated in times of supreme confidence and is only realized in times such as these. In the race for returns when confidence is soaring, we seldom pay heed to the prudence of genuine diversification. This is an opportune time to understand how diversified you really are and how vulnerable your portfolio is to extreme events.
Dangers in point estimates
Point estimates of portfolio holdings are dangerous to determine performance and that performance fees to your investment adviser are better staggered over extended periods of time. Extreme events happen rarely and only time can ferret out the hidden dangers lurking within portfolios. Keeping adviser fees tied to long-term performance ensures not just advisers keeping a long-term view and dissuading them from taking short-term risks that are fraught with danger, but also reduces the possibility of investment advisers being rewarded for simply riding a boat in the high tide of buoyant markets.
Booking short-term capital losses
No doubt each investor’s situation is unique. However, for those whose investments do not fall under business income and were caught in the frenzy of pyrrhic stock prices followed by the current savage write downs, may do well to (especially in highly speculative positions taken within the last one year) sell at a loss and book short term capital losses. These short-term capital losses, can be used to offset future short term capital gains that may be incurred in liquid or debt mutual funds under the growth option. Investors may be aware that since the last budget, debt mutual funds are now subject to short term capital gains for any term below 3 years. However if an investor generates short-term capital losses similar to the one just described, these short-term capital losses can be offset against future short term capital gain from the sale of liquid/debt funds within a 3-year term. This is even more advantageous in the case of an individual in the highest tax bracket who will be able to tax shield his debt investment gains and simultaneously get rid of unnecessary speculative positions that he should not have entered in the first place. This is simply a generic approach and should not be used without a detailed analysis. I urge the reader to consult her investment adviser for advice that would cater to her specific situation.