While it is difficult to take a call on market directions, there are certain basic principles which, if followed, may help investors navigate volatility in a rising market environment.
A rising stock market is generally considered favourable for investors given the scope of significant wealth creation due to increase in stock prices. However, a rising market environment has its own set of challenges, especially in the latter stages as expensive valuations and the possibility of market corrections lead to confusion & fear in the mind of investors.
While it is difficult to take a call on market directions, there are certain basic principles which, if followed, may help investors navigate volatility in a rising market environment.
In a rising market environment, valuations tend to be on the higher side, which might result in low or negative returns in the near term. In such an environment, investors need to invest with a 3-5 year view and should ignore near-term volatility. Therefore, they should only commit long-term money and avoid investing any surplus which they might need over the next 1-3 years.
“Moreover, investors should not get carried away with their emotions and stick to their long-term asset allocation plan. Therefore, it is important to keep reviewing and rebalancing the portfolio at a predetermined interval to ensure that actual allocation is in line with the desired levels. This will help investors keep booking profits at regular intervals and ensure adequate allocation to less risky assets like fixed income, thus ensuring liquidity which will be used to increase equity allocation in case of any market correction,” says Manish Jeloka, Co-head of Products & Solutions, Sanctum Wealth.
SIP is a better alternative to lump sum for new equity allocations
When the markets are rising, investors should consider doing an SIP spread over 6-12 months rather than making a lumpsum investment. This will allow them to take advantage of any market volatility while reducing the risk of major losses due to any sudden adverse market movements.
Invest in long-term compounders with a strong business model
One of the basic tenets of investing is to buy into companies with strong growth potential, business moats and cash flows. Investing in companies with strong fundamentals will help investors generate markets beating returns in the long run despite any possible short-term pain due to adverse market movements.
Consider valuations while investing
While it is important to look at the fundamentals of a stock before investing, it is also important to pay the right price for businesses. Great companies will always trade at a premium to the markets given higher return ratios and growth rates. While investors will always need to pay a premium for buying into great businesses, one should not overpay as it will lead to erosion in returns.
“As a rule of thumb, valuations should be considered as reasonable as long as the stock is trading within one standard deviation above its last 5-year average valuation multiple. However, in case the stock is trading three standard deviations above its last 5-year multiple, then investors should wait for valuations to come down to a more reasonable level before investing,” suggests Jeloka.
Avoid companies with weak business models
One of the biggest mistakes that investors make is to invest in companies with weak business models just because they are cheap in terms of P/E or P/B multiples. One should, therefore, not invest in a company just because they are cheap in terms of valuations as they prove to be value traps more often than not.
These companies will typically have low growth rates & return ratios, stretched balance sheets and corporate governance issues which explains the lower valuation multiples. Investors should avoid investing in such companies at all costs as they will continue to trade at discounted multiples and are very likely to give lower than market returns in the long run.
