Nothing is permanent in the stock market so don't let your emotions ride it
If you forget that market trends are not straight lines but circles, then you could be needlessly giving yourself a hard time.
Over the past year, it’s been hard to talk to an equity analyst or trader without getting an earful about the poor performance of mid-and small-cap stocks. Over this period, the Sensex gained by about 12%, while the mid-cap index fell by about 1% or so and the small-cap index fell 5%.
As always, the universe of mid-cap and small companies is much more diverse, which adds to complaints. Among the constituents of the BSE Midcap index, there are eight companies that have returns of more than 40% for the year, while at the bottom, there are eight that have declined by more than 40%. While this symmetry is a coincidence, the general shape of returns is not. The small-cap index also has almost as much diversity in returns. The same principle applies to mutual funds, although the extremes of returns are obviously not there because the fund managers (mostly) eliminate them.
Even so, there’s a certain pointlessness to this complaining about mid-caps and small-caps. The reason is if instead of looking at one year, investors look at longer periods like five or 10 years, then the picture becomes clearer. Over the past 10 years, the Sensex has given an annualised return of 10.34%, the mid-cap index of 11.15%, and the small-cap index of 9.42%. The total accumulated increases were 2.7 times, 2.9 times and 2.5 times, meaning there’s hardly anything to choose. Over a long period, the returns are identical for all practical purposes.
Of course, during the intervening years there were many periods when this symmetry was invisible. One or the other type of stock was racing ahead, while others lagged. However, a look at the history of equity prices shows that there are cycles of different types of stocks doing relatively well or relatively badly. Over time, as one goes through a complete set of cycles, the returns even out.
More important is the conclusion that one can draw about investors’ behaviour. Far too many people think every trend that is currently extant to be extendable into the future. If mid-caps and small-caps are doing badly then they must continue doing badly, going from bad to worse. In the very recent past, there were plenty of investors who thought the same anout large-caps. They would invent complex reasons as to why the Indian large-cap story was over.
However, all that is needed is experience and a memory of all the times when current trends seemed strong, but when the cycle turned, they disappeared. This awareness of the fact that nothing is permanent and that everything comes around is what distinguishes experienced investors from those who merely spend time in the markets.
So what really matters is not the market cycle but what I’d call the psychological cycle of investors. As the market goes through different phases of its cycle, your mental state also goes through phases in response. In the end, whether you make money or not and whether you meet your life’s financial goals depends on what stages your psychological cycle are in and how you manage them.
These psychological cycles can be understood as a sequence of mental states. Starting from a point when the market just starts rising from a previous low, this sequence could be something like this: Optimism, Enthusiasm, Exuberance, Euphoria, Anxiety, Denial, Fear, Despair, Panic, Discouragement, Dismay, Hope, Relief, and back to Optimism. It’s obvious what stage of the market maps to which emotion.
You’ll find a great deal of gyan on what are the best points on the cycle to invest in. The diagrams will mark the ‘Euphoria’ stage as the point when greed is the highest and this is the worst time to buy. Similarly, the ‘Dismay’ stage is pointed out as the best time to invest. This, like many obvious things about investing, is useless. The reason is all this makes sense only in hindsight. Things look different when you are living through them. At the end, you learn your lesson about sticking to quality investments, and then when the cycle begins again, you’re fine.
Instead of that list of ever-changing emotions, you have one or two emotions, which stay with you permanently. These are watchfulness, and quiet confidence. At that point, the cycle does not matter, you’ve banished it from your investment experience.
(The writer is the CEO, Value Research)