When our portfolio shows a sharp correction, then the normal reaction of one of panic! For example, the index may down by just about 5% but if your portfolio had a huge exposure to PSU banks or to mid caps then your damage to the portfolio could be to the extent of 15- 20%. What should you do when your portfolio shows a 15 to 20% correction in a short span of time? Quite often, the response is to panic and sell out by booking the loss. That is exactly what you should not do. A more calibrated approach will be more meaningful.
Violent corrections in the portfolio are nothing new. We have seen sharp corrections in 2000, 2004, 2008, 2011 and again in 2013. During extreme periods like 2000 and 2008 even the mutual fund NAVS were down by 60-70%. That is what carnage is all about! The bigger question is how investors should react to such a situation. Be patient is easier said than done. When markets correct sharply, the need of the hour is a calibrated and systematic approach. Here are some interesting rules to live by when you see such a violent correction in your portfolio. Adding more or jumping out is not the answer.
A sharp correction is normally the time to a strategic reallocation of your portfolio
Review your overall asset allocation. Does it make sense to continue current exposure to equities or should you park your money in a debt mutual fund or ever a liquid mutual fund. Shifting has a cost but it would be smarter than just watching your portfolio value depreciate further. That would be just too passive an approach. Stock selection is never easy when markets are volatile. Most investors use discrete options like adding more or exiting altogether. The truth, normally, lies somewhere in between.
Go long on strength and short on weakness
When the market is correcting, it typically separates the men from the boys. Normally, the stocks that caused the froth will be the weak stocks. 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. But there will also be stocks that are more defensive like FMCG that hold value a lot better than these stocks. One of the best things you need to do is to exit these frothy stocks immediately. No two bull markets have been led by the same set of stocks, so don’t make the mistake of averaging such stocks. But into strength; stocks that are falling less than the index.
Losses reduce taxes so you must do loss farming where possible
This is popularly used by many large investors who understand the concept of tax shield on losses. If you are holding on to an equity fund and it is down in the last 10 months, you can book a loss on this stock and write off the loss against the other profit sources. There is a transaction cost to it but it is hardly anything compared to the taxes that you save on gains. MTM losses don’t give you any benefit. Of course, you can always buy back the stock later but the tax shield is a useful positive flow to you. In fact, by farming losses you hardly lose anything but the notional loss is converted into a real loss and reduces your overall tax liability. What if you don’t have profits to write off? No problem; you can still book these losses and carry forward for a period of 8 years. Where you have losses, use the tax shielding strategy.
Be systematic in these conditions rather than adventurous
When markets are cracking, never try to predict the market. That does not make sense. You do not know at what level the market will bottom out and you never will. Focus on managing your risk. Also ensure that your long term goals are not impacted in any way as equities will eventually outperform other asset classes. For a 20 year goal, such corrections do not matter. If you are doing an equity fund SIP, use your discretion and increase the size of your SIP when markets are down so that your average cost comes down.
There is nothing like buying good stocks cheaper
So, it is time to selectively roll your shopping trolleys out. Let us look at it this way. You were happy to purchase RIL at 1400 then why do you shy away at Rs.1100? That is the fundamental question and it makes a lot of sense. Don’t jump and buy any stock that has corrected. A sharp correction is a golden opportunity since you get quality stocks with great fundamentals at attractive prices. Here is the time to look for bargains and buy quality at cheap prices.
Finally, in a correction the head should always rule the heart
This may sound philosophical but is important to your decision making process. Let your logical judgement and reasoning prevail over your emotions. For example, emotions may drive you to average the stock that has corrected over 50% in 3 months but logic may tell you that you will end up overexposing yourself to technology stocks. In such situations, let your logic rule over your emotions. That is a recipe to handling such market corrections.
More often than not, market corrections are a great opportunity for serious investors. It is the time to actually restructure your portfolio and align it with your long term goals.